Cheering the Market Drop

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 third of a five-part series. Other installments are linked in the box at the right of the page.

Rex: You've really uncovered some remarkable winners, some great companies. Solid names like Middleby (Nasdaq: MIDD  ) and Mine Safety Appliances (NYSE: MSA  ) that most people still haven't heard of. Why isn't Wall Street all over them? How is it that promising small companies can fly under the radar for so long?

Tom: First, there really is no compelling reason for analysts to cover them. I believe that your average Wall Street stock analyst is bright about business and investing. However, they operate with a very serious conflict of interest. They work at very large investment firms who want them to either generate trading commissions for the brokers on staff OR indirectly help build banking relationships with the companies they cover.

Among small-cap stocks, there are very few sizable offerings -- secondaries, debt issuances, etc. -- for firms to get excited about. Furthermore, the customers of most of these firms are not interested in being traded into and out of small, unknown businesses. Why, then, would the major firms direct their analysts to spend much time on pint-sized public companies?

That lack of coverage gives investors like us a delicious opportunity to track down well-run businesses selling at discounted prices due to their obscurity.

Of course, there are money managers with multi-billion dollars that do quite a good job with small and micro-cap stocks. But, on average, the large firms don't have too much money to allocate toward small caps. Furthermore, their clients are pretty conservative.

Peter Lynch made this point wonderfully in One Up on Wall Street. He shared why he loved buying stocks like Pep Boys (NYSE: PBY  ) . The very name of the company sounded silly to everyone on Wall Street. What customer would buy that? Why would you buy that when you could pick up shares of IBM (NYSE: IBM  ) or Pfizer (NYSE: PFE  ) , play it safe, and get your fees and commissions? Lynch said that if IBM stock did not do well, clients would call up their broker and ask, "Hey, what's wrong with IBM?" But not so if you recommended Pep Boys. If it didn't do well, the clients would call up and ask, "Hey, what's wrong with you?"

Small caps just weren't worth the risk.

Rex: All right, let's back up and take a look at the market as a whole. We had a really nice rally last year but things aren't going as well this year. Are you uneasy about this market? Do you even care about what the market is doing right now?

Tom: I really don't care about the macro issues. In my company-by-company analysis, I certainly feel pain in a rising market. As it climbs, there are fewer bargains. Rising markets draw in new investors. But if we were smart as investors, we'd really get excited when common stock prices across the board got cut down. Let's take eBay (Nasdaq: EBAY  ) as an example. No matter how you feel about its current valuation, two broad market declines in the past five years have presented wonderful buying opportunities for the stock.

Logic dictates that with every step higher that the market takes, fewer companies are meaningfully undervalued. Because I like to target small-cap stocks that I think have a decent shot of doubling over the next three years, rising markets can get very painful. Falling markets are a long-term blessing. So, I just keep my head down and look for one bargain at a time. I feel market overvaluation at the ground level.

Rex: Do you really think you can find one "three-year double" after another?

Tom: Certainly not. But I aim that high knowing that I'll make mistakes. If I demand a reasonable shot at 25% per year growth before buying a small-cap stock, so long as I don't start speculating, I think that greatly heightens the chance that I'll generate 15% per year growth for Hidden Gems members.

Those opportunities get more and more difficult to achieve as the market climbs. I know how contrary it is, but in fact if you can calm down as an investor and foster in yourself a willingness to own companies for three to five years, then across-the-board price drops create wonderful opportunities. Thinking that way will do more than relax your nerves in down markets. It'll motivate you to dig up more savings and put it to work in the equities markets.

Rex: Are you saying you cheer the market down?

Tom: Sure, whenever I'm thinking of buying a stock. I love it when a business I believe in stumbles in a single quarter. All the momentum traders bail. The stock gets sliced in half. If the foundation for long-term operational success is still there, what a gift!

Market declines, like the one we're now enduring, present opportunities for net buyers of stocks. Yet still, it comes down to doing the due diligence analytical work on each business and stock before buying.

Tom's average returns in Hidden Gems are well ahead of the market. A no-risk,free trialgives you access to two selections each month, plus the complete Gems archives.

Tom Gardner owns shares of Pfizer. The Fool has a disclosure policy.


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