Why Some Investors Think the No. 2 Stock Is Best

Libby Kane
Posted

In the stock market, as in most places, first place is where you want to be.

The strongest company in an industry–the one earning the most money–is often perceived as reliable, steady and a safe stock to add to your portfolio. In that way, money begets money: The company is financially solid, so people buy its stock, so it stays solid.

Here’s another take: It might be the second-best company in an industry that most benefits its shareholders. SmartMoney reports that financial advisors and investing experts are bypassing the leader of the pack to invest in the second-strongest company in any given industry.

If investing in the biggest company is the safest bet, why would experts recommend investing in the second-biggest? And if that’s their advice … should we be following it?

Why Second-Biggest Is Most Promising

The stock in the second-biggest company in an industry could be the best investment for three reasons:

1. It’s cheaper.

One measurement of a company’s potential for growth is the price-earnings ratio, which shows how much an investor is willing to pay per dollar earned by the stock. The second-biggest company is likely to have a lower price-earnings ratio than the leader, which means that investors can get a better deal.

2. There’s more room for growth.

When a company dominates the marketplace, there’s only so much left to conquer. But for the second-biggest company, there’s opportunity to build its own consumer base and to use its lower prices to appropriate audience members from the strongest company. Especially during this economic recovery, the top-slated company might find that consumers aren’t willing to pay more for the leading brand, and may sacrifice quality and consequently damage profits to stay on top. Number two, less desirable already simply for being second, is unlikely to face a similar dilemma.

3. It could become number one.

Smart Money points out that number two companies are often able to focus solely on taking out the industry leader, refining and perfecting their approach, having already eliminated any larger, systemic issues on their climb up to number two.

Right now, some of the second-biggest companies whose stocks are getting noticed are Chevron (behind Exxon in oil and gas exploration), Progressive (behind Allstate in insurance), Kimberly-Clark (behind Procter & Gamble in consumer essentials), Capital One (behind American Express in credit cards), Spotify (behind Apple iTunes in music) and Peet’s (behind Starbucks in coffee and tea).

So, Should You Invest in Number Two?

It’s always a good idea to keep abreast of trends in the economy and the market–but you know that, which is why you’re getting The Market newsletter! That said, we don’t recommend picking and investing in individual stocks. While some number two stocks are an investing advantage, not every one is.

Instead, we suggest investing in mutual funds, which spread out your risk by putting your money in pools of stocks, bonds or other investments run by a money manager. Investing in a mutual fund instead of individual stocks makes it easier for you to diversify, which keeps your money safer overall.

Of course, everyone’s financial situation is different. If you’re not sure where you should invest, start by taking our risk tolerance quiz to figure out which kinds of investments are best for you. Then, keep an eye out for Investing Bootcamp, our newest seven-day email program, to walk you through everything from mutual funds to dividends. (Can’t wait? Brush up on your investing know-how in the Knowledge Center.)