3 Promising Stocks That Aren't Industry Leaders (Screens)

Buy shares of companies that lead their industries -- that sounds like reliable enough advice, doesn't it? After all, top dogs often have the most bargaining power with suppliers, the biggest research budgets and the brands that everyone recognizes.

There's just one problem: Industry leaders tend to lag behind peers in producing stock returns, according to new research.

The findings come from Robert Arnott, who is something of an investment myth-buster and the founder of Research Affiliates, a firm that devises "fundamentals-based" stock and bond indexes for passive investors seeking a performance edge. In the June edition of his firm's newsletter, Arnott tackled the belief that industry leaders offer market-beating stock returns. Prior research had shown that measures like profit margins and returns on equity tend to revert to their means over time. That is, the most profitable companies tend to attract fresh competition, while profit laggards often either fail or are forced to improve. Arnott looked at U.S. stock performance over 58 years ended 2009 and found that sector leaders by market value in a given year tended to underperform their peers by an average of 3.3% a year over the following decade. Leadership proved fleeting. Over the entire 58-year period, the average sector saw its leader change six times.

So much for investing with No. 1. Below are listed three companies that don't lead their industries in size or profitability, but whose margins are improving and whose sales are growing faster than those of their peers.

Projected sales growth, current fiscal year: 36%

The packaged food business is dominated by giants. Kraft Foods (KFT), based 30 minutes north of Chicago, is expected to generate sales of nearly $49 billion this year, and Switzerland's Nestlé should more than double that. Diamond Foods (DMND), based in San Francisco, isn't projected to top $1 billion this year or next. The company has a hit on its hands, however, in chip-maker Kettle Foods, which it bought earlier this year for $615 million. Management says demand for the brand is so fierce it must add production capacity. Diamond's namesake baking nuts and its Emerald snack nuts are selling well, too. Demand for its Pop Secret popcorn has been flat of late, but management is investing in new commercials. Companywide sales are forecast to jump 36% this year, thanks largely to the acquisition, but investment bank BMO Capital Markets estimates that Diamond will generate 8% to 12% of organic sales growth – well faster than the internal growth its big competitors typically achieve.

Projected sales growth, current fiscal year: 27%

Netgear (NTGR) and Cisco Systems (CSCO) both sell networking equipment. The latter is 50 times larger by sales, but the former is expected to increase its sales twice as fast this year. Netgear specializes in products for homes and small businesses, including Wi-Fi routers, print servers, centralized storage systems and boxes that allow users to share their 3G and 4G cellular connections with other devices. Management's latest push is centered on devices that allow users to view Internet content on their televisions – and that allow any company that can deliver a broadband connection to compete with cable television providers. Operating margins for the company have recently topped levels achieved in early 2007, before the start of the recent recession. Netgear is debt-free and holds cash equal to more than one-fifth of its stock market value.

Projected sales growth, current fiscal year: 26%

Watson Pharmaceuticals (WPI) is the third-largest generic drug company operating in the U.S. by number of prescriptions dispensed, behind Teva (TEVA) and Mylan (MYL). Its sales are expected to grow faster this year than those of its larger peers. Unlike legacy drug makers, Watson stands poised to cash in on the parade of patent expirations on blockbuster medicines over the next several years, not shrink during it. For example, Watson will be one of the first companies to sell a U.S. generic form of Lipitor, a cholesterol drug with yearly U.S. sales of more than $7 billion, beginning in November 2011. Management says that in addition to six products launching this year, it has 110 applications pending, including 13 that would bring exclusive marketing rights.