Small Stocks, Big Gains

This column originally ran on April 7, 2004. It has been updated.

Hey, have you been hearing about this Hidden Gems investing strategy but aren't quite sure what it is? Want to learn more about the methodology that has produced a 29% average gain -- vs. the S&P 500's 3% rise (calculated using the arithmetic mean) -- since the newsletter launched in July 2003?

Good, because we're excited to share it with you. Today, we'll talk about the most basic of the guiding principles behind the Hidden Gems philosophy: Buying small companies offers some advantages to us small investors.

Let's get small
Hidden Gems concentrates on small businesses. For us, this generally means stocks with a market capitalization of $200 million to $3 billion. By comparison, eBay (Nasdaq: EBAY  ) is worth about $43 billion -- and Microsoft (Nasdaq: MSFT  ) , Wal-Mart (NYSE: WMT  ) , and General Electric (NYSE: GE  ) are in the $250 billion-$300 billion range!

Our challenge is to find those "small caps" with a sturdy capital structure, top-flight and nonpromotional executives, prospects for years of cash flow growth, and an inefficiently low price tag on their business.

So, that's what we want. Now, let's talk about the advantages of investing in smaller businesses.

Thin and rich
We're interested in companies that are too small and too thinly traded to attract much Wall Street coverage. Most institutional investors, who have billions and billions of dollars to allocate, also avoid these small pints.

That makes them underfollowed and increases the chances that they're undervalued. Why? The less activity in a marketplace or auction house, the higher the probability of pricing inefficiencies. When there is only one bidder for a Michael Jordan autographed game jersey, the chances for mispricing are infinitely higher than when thousands of investors bid every day on the present price of IBM (NYSE: IBM  ) or Pfizer (NYSE: PFE  ) stock. That inefficiency provides opportunity for private investors.

This chance for pricing inefficiency is even higher because the brightest investment minds (think Buffett) are priced out of small caps. Because they invest with billions of dollars, their professional success attracts more money, forcing them farther out of the small-cap arena. They simply can't buy enough shares of a small-cap stock to make any meaningful difference to their overall investment returns, so they disregard these companies.

What's left for small investors? Less pricing efficiency and more opportunity for success among small-cap stocks.

Of mice and men (and pachyderms)
Look at it another way. Warren Buffett has said he's having a hard time finding bargains these days. In his 2002 annual report, the Berkshire Hathaway (NYSE: BRK.A  ) (NYSE: BRK.B  ) chairman wrote: "Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us." And the S&P 500 is up some 25% since he wrote that! If Buffett can't find bargains, why should we believe it's possible?

Think of the Oracle of Omaha as a big ol' investing elephant. A brilliant elephant. But an elephant who needs about 300 pounds of food per day. After eating up a couple of large plants, an elephant can look around and say, "There just isn't much left here for me to eat."

Now, think of us -- as small investors with just tens of thousands of dollars to allocate -- as mice. A mouse eats some 50 grams per day, or about a tenth of a pound. Where an elephant sees nothing to eat, a mouse can sniff around and find loads of munchy morsels. In other words, we can feast away on stocks that the big boys might like but don't bother with since a few grams of profit won't help them at all. Our goal is to find the most promising small companies that one day will grow large enough to attract the elephant investors.

Let's get beyond the visual analogy. The fact is, we have fewer investors in our small-cap territory, fewer geniuses, and fewer bids in a given week or month. Of course, these stocks -- because they are underfollowed -- will be more volatile. Small-cap investors know that a $500 million company can see its price rise or fall 25% in a single month... without meaningful news on the operations of the business. That short-term rise or fall may faze some investors. So, if this kind of volatility will drive you crazy, don't put your money here; there are better places for it.

Small capping it off
Because of this volatility, we recommend that -- when tracking down hidden gems with us -- you (a) diversify through a total market index fund, (b) remain focused on a three- to five-year time horizon, and (c) not risk so much of your investable assets that radical price changes in the short term put your emotions into play.

But, no hurry... you can decide to take a free trial with us anytime you wish. In the meantime, start to think small, and enjoy reading more about the Hidden Gems investing philosophy:

Tom Gardner is co-founder of The Motley Fool and an all-around good guy. He owns shares of Pfizer and Microsoft. Rex Moore is co-founder of the Sea Monkey Rescue Group and an all-around great guy. He owns shares of eBay, Microsoft, and Berkshire Hathaway. The Motley Fool is investors writing for investors.

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