Don't Discuss This Investment at Cocktail Parties

Question: What is the best-performing stock of all time?

Answer: Philip Morris (now called Altria), the infamous cigarette maker.

Philip Morris' success illustrates one of the fundamental rules of investing: Hated investments perform best. Popular investments lose money.

That's why it's easier to get rich cleaning sewage tanks than opening wine bars. People don't like to get their hands dirty, so it's cheaper to get involved.

Take Philip Morris, for example. Investors have had low expectations for Philip Morris for decades – ever since people figured out its product causes cancer and generates massive lawsuits. But people kept smoking, and Philip Morris kept cranking out steady earnings and large dividends.

If you'd invested $1,000 in Philip Morris in 1925 and reinvested the dividends, your investment would now be worth a quarter of a billion dollars. No other stock can match that performance.

The railroads are another great example. Would you have bought railroad stocks in the 1960s? The U.S. was constructing its interstate highway system, and everyone could see that trucks were about to steal the railroads' share of the freight market. At the same time, the commercial airline industry was maturing and would steal all the railroads' passengers.

The railroad industry collapsed for nearly five decades... between 1957 and 2003, the railroads' share of the S&P's industrial sector declined from 21% to 5%. Yet – according to Jeremy Siegel in his book, The Future For Investors – railroad investors not only beat the S&P, they thrashed returns from the trucking and airline industries, too. BNSF – one of four surviving major railroads – has averaged 17% annual returns since 1980... beating the S&P 500 by 4% per year.

How is this possible? Simple. When investor expectations become so depressed, it's easy for a company to do better than everyone expects... even firms in declining industries. And this produces fantastic returns for investors. So how can this knowledge help you profit now?

I spotted an interview with Peter Siris in this week's edition of Barron's. Siris is the author of Guerilla Investing and manager of a hedge fund called Guerilla Capital management. His fund has returned 15.6% a year since 2000.

"I've never visited a gentleman's club," says Siris. "But I recognize a good business when I see one."

These clubs generate extraordinary cash flows. Customers pay large mark-ups for drinks and a cover charge to get in. The dancers pay a fee to perform and get to keep the tips. According to Siris, gentleman's clubs generate 90% gross margins and 40% profit margins. "It's my kind of business where you charge both customers and employees to walk in the door," he says.

Strip clubs have huge barriers to entry because no one wants them in their neighborhood, and the market is extremely fragmented. The industry leaders only control 1% of the market, so there's plenty of scope for consolidation.

This can be an extremely profitable enterprise. Problem is, this business is taboo. It exploits women, and everyone thinks mobsters control it. So no one wants to own a strip club. The result: Publicly traded gentlemen's clubs trade at low valuations - with P/E ratios around 10 – because institutions won't buy the stock.

Siris has invested in two publicly traded strip-club operators: Rick's Cabaret and VCG Holding. "The reality is these are well-managed public companies that have to follow all the rules," Siris concludes.

I'm not saying go out and buy shares in gentlemen's clubs... simply pointing out that many of the greatest stocks of all time are in hated or ignored industries. The next time you'd rather crawl in a hole than explain your investment at a cocktail party, keep this in mind.

Good investing,

Tom