Tom Gardner receives dozens of questions each week about hisHidden Gemsinvesting philosophy, one that is soundly beating the market. Fellow Gems team member Rex Moore recently pulled together the most common questions for an interview with Tom.
This is the second of a five-part series. Other installments are linked in the box at the right of the page.
Rex: You have averaged 28% returns in Hidden Gems so far in a flat market. Yet of your 14 selections, four are down over 20%. Would you consider that life as normal for small-cap investing?
Tom: In the short term, yes, it's pretty common. Small-cap stocks can be extremely volatile. Investors in Taser (Nasdaq: TASR ) have seen the stock rise nearly 1,400%, fall 60%, rise 80%, and fall 45% -- and all of that's just over the past year! For another example, just look at Nam Tai Electronics (NYSE: NTE ) . Neither of those are Hidden Gems selections, by the way, but I'm sure our members will see that kind of volatility over the years in some of my recommendations.
I don't have as a goal trying to avoid volatile stocks. My baseline goal in Hidden Gems is to not pick stocks I think will sit below today's price five years from now. That's my view of searching out permanent value and trying to preserve wealth. I ask myself, "Is it likely that this business will be valued higher than it is today, in five years?"
Obviously, I'm looking for much greater returns than that. But that's how I define a long-term margin of safety.
Of course, I'll make mistakes. Real blunders. I'll pick some bad businesses, having misestimated management, and I'll watch their value decrease over time. But separate that completely from stock-price movements in the short term. Stock price volatility does not equal business risk, no matter what the academics say. In the case of some of my 20%-plus decliners right now, I'm cautiously very optimistic about their long-term prospects.
Rex: What do you do when one of your stocks takes a short-term hit?
Tom: Yoga. Start by breathing! (Laughs.) When I see a stock dive -- either after material news or, lately, simply because the market is taking a hit -- I sit down and evaluate the business. Has anything really changed about its three-to-five-to-10-year prospects? Have I made any mistakes in my valuation work? In many cases, I like the investment even more at the lower price.
From there, one of the key features I provide in Hidden Gems is a monthly update on the stocks that I've recommended. I refresh my analysis and provide buy-below prices. And I'm not at all averse to averaging down if I think I've got a great company that's being temporarily unfairly treated. The only key point there is that I do not overweight positions.
But that's the blocking-and-tackling of investing. If we step back and look at the deeper philosophy, for me it starts with accepting that I will have some substantial winners and some losers. There's no question in my mind that over the next 10 years, I'll have some companies that rise more than 10 times in value. I believe the restaurant I recommended the last two months in Hidden Gems holds out a nice shot at being a 10-bagger.
But then it comes with the territory, that I'll also have some stocks that I'll sell after they've fallen 50%.
Rex: That doesn't cause you to lose sleep?
Tom: No, and here's why. Let's take two $10,000 investments that we might make. Imagine that the first of them, an investment in SnowMobile.com (ticker: SJOB), falls 50% over the next 10 years, and then I sell. What a depressing investment that is. I put $10,000 in and let it sit for 10 years and then only get half the principal back. Disgusting.
Then my second investment, let's rewind to 1994, is in a growing retailer named Bed Bath & Beyond (Nasdaq: BBBY ) . I buy, hold, and it rises 10 times in value. That 10-bagger takes my investment up to $100,000. Along the way, the stock rocketed back and forth, but I saw the business developing, with strong same-store sales, a solid balance sheet, consistency in the executive ranks, and shareholder-friendly actions.
What am I left with after 10 years? My first investment has been reduced to $5,000. My second investment has risen to $100,000. I put $20,000 in, it has grown to $105,000, and I've earned annualized returns of 18%. That's an example of "10-bagger magic."
That's a perfect example of why my biggest mistake in sister newsletter Stock Advisor was not a poor business or a losing stock. No, it was my decision to sell Sanderson Farms (Nasdaq: SAFM ) after a 70% one-year gain. Since I sold, it has nearly tripled. Now that is disgusting.
So I'm willing to accept a collection of winners and losers, with a few super-long-term dramatic winners in the mix. That's small-cap investing for me. Of course, I know that it can be distressing for individuals to see any stock they hold lose value. And it is my goal, as I said, to have no stocks that lose value from the price that I buy them over the next five years. But all in all, I'm willing to travel the extremes, particularly in the short term, so that I can enjoy multi-baggers over the long term.
For me, the work begins with valuation, an evaluation of competitive advantages, a careful look at management, and then it extends into a willingness to average down when you believe you have a sound company and a discounted stock.
Tomorrow: Why Wall Street misses most small-cap winners.
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Tom Gardner owns no companies mentioned in this article. The Fool has a disclosure policy.