Is it possible to pick the next REA Group Limited?

Online property advertiser, REA Group Limited (ASX: REA), has been one of Australia's best-performing stocks over the past decade and remains an exceptionally strong company. Over the past four years,

• Return on equity has averaged 40%
• Profit margins have averaged over 30%
• Revenue has grown by 22% per year
• Earnings per share have grown by 30% per year

REA Group is now a $5 billion company and so is unlikely to be able to maintain such impressive performance in the future. Is it possible for investors to identify the next group of stocks most likely to achieve similar outperformance over the next decade?

The case against

There are many problems with picking out the best performers of the past, and studying them to try and predict the best investments of the future. Here are just a few.

1. Luck always plays a major part in determining which companies prosper and which fail. Just because everything turned out perfectly for REA Group, doesn't mean that things couldn't have been very different.
2. Whilst it might be possible to identify some common traits among top performing stocks, the same traits may be present in many other underperforming stocks and are therefore not reliable indicators.
3. Business conditions are constantly evolving and so what worked in the past, may not work in the future.

These problems are compounded by the fact that it takes years for an investment thesis to play out and so there is a long delay in receiving useful feedback required to improve stock picking methods. To make matters even worse, the market constantly provides false feedback in the form of short-term price fluctuations that can throw investors off the scent.

Rather than trying to pick the next "ten bagger" stock with massive potential, investors are better off sticking to companies with a proven track record trading at bargain prices. Whilst the rewards on offer may seem lower in absolute terms, they are likely to be higher on a risk adjusted basis.

The case for

It would be naïve to think that it is possible to find the best performing stocks over the next 10 years solely by looking for companies that share some of the qualities that led to REA Group's success. However, ignoring such qualities would be equally unwise.

Whilst luck plays a major role in the success of any business, so do its strengths and weaknesses. Investors can improve their returns by identifying companies with the right set of qualities, and studying the likes of REA Group can help with this process.

Of course, it is equally important to identify negative qualities and so it is also necessary to observe weak stocks to know what to avoid.

Here are a few of the many reasons why REA Group has gone from strength to strength.

1. It operates in the property market which is a strong industry likely to thrive for centuries to come, regardless of the odd possible market crash now and again.
2. It is the dominant player in Australia's online property advertising market giving it the power to raise prices without risk of losing customers. This was also the case back in 2003 when REA Group's shares traded for around 50 cents and the company was barely profitable.
3. The company successfully positioned itself to benefit from a huge tailwind in the form of the internet's disruption of much of the advertising industry.
4. The business model is highly scalable since as a digital business, it does not require significant investment to grow its customer base. Any investment that is required can be completed relatively quickly.

Foolish takeaway

Many small companies, unlike their larger counterparts, have the potential to grow rapidly relative to their size and deliver equivalent share price gains. However, they also have the potential to lose much of their value since they are more susceptible to external factors.

Personally, I prefer small-caps mainly because I think there are more bargains to be had at this end of the market. Big companies with a proven track record tend to be more efficiently priced because they are usually easier to value and more widely known.

I invest my money in small-caps whilst recognising that the sector is inherently risky and other people may not be comfortable accepting this level of risk. Regardless of the types of stocks you invest in, the rules of value investing remain unchanged.

1. Buy only high quality companies, with good management, operating in favourable industries.
2. Only buy them for a price which is much less than their fair value.