Want to Find Home Run Stocks? Look for This

I think it goes without saying that you would love to see returns like these in your portfolio:

Source: Capital IQ, a Standard & Poor's company.

These were the top performers in the "lost decade" of the 2000s. But how do you score home run stocks like these? As my fellow Fool Tim Hanson has pointed out, you look for small and ignored companies, a description that fit all of the above companies a decade ago.

Many mutual funds are simply too large to be able to buy meaningful amounts of smaller companies, and so they're stuck trying to juice returns from huge blue chips like ExxonMobil (NYSE: XOM) and Johnson & Johnson (NYSE: JNJ).

Don't get me wrong, both of these are great companies. ExxonMobil should continue to benefit from the increasing global demand for oil, and its size and reach will hopefully give it better access to harder-to-get-to reserves. Meanwhile, Johnson & Johnson has taken some nasty lumps lately, but it's still a very solid company and will likely leave the current problems in the history books. Better still, I think the valuations for both companies look fairly attractive right now. But the simple truth is that you're just not going to see these two soar 5,000% over the next decade.

Meanwhile, the tiny up-and-comers that can provide massive returns are completely ignored, which gives individual investors a fantastic opportunity to find them before Wall Street does.

There's a but ...
While there are no optical illusions or sleight of hand in that chart above, it's worth noting that while the absolute best performers over the past decade were small-cap stocks, small caps also accounted for about 95% of public-company bankruptcies.

With that in mind, we could probably say, "Live by the small cap, die by the small cap." That is, unless we could find something that separated those top-performing small caps from those that went belly up.

Will any idiot do?
To try to find a way to separate the wheat from the chaff among small caps, I decided to start at the top -- the top of the management team, that is. For each of the top-performing companies and 10 randomly selected bankrupt companies, I dug up proxy filings from a decade ago to get a look at who was steering the ship.

What I found was frankly a little surprising, but it wouldn't shock Fool co-founder Tom Gardner at all; he has been crowing about this for some time. What am I talking about? Insider ownership.

Here's a look at the CEO's ownership stake in each of the successful companies:

Source: Company filings.

Compare that with the ownership levels for the companies that went bust:

Source: Company filings.

The CEOs of the bankrupt companies didn't completely avoid share ownership, but it's pretty easy to see that on average, the heads of the successful companies owned a far larger percentage of the companies they managed.

In addition, the CEOs of the successful companies were far more likely to be one of the company's founders. Half of the CEOs in that first list were founders, while there is only one founder/CEO in the second list.

This certainly doesn't mean that the CEOs will always hang onto their stake. Amedisys CEO William Borne, for example, has significantly reduced his stake over the years and currently owns less than 1% of the company. But starting with a big ownership position means that simple self-interest will encourage the CEO to maximize the company's equity value.

A step in the right direction
Insider ownership by itself is certainly no silver bullet. Looking back to 2000, both Broadcom (Nasdaq: BRCM) and Amkor Technology (Nasdaq: AMKR) had insiders with significant ownership positions. Both companies'  operating income has grown over the past decade. And today analysts continue to project significant growth ahead for both companies.

But that all matters little to investors who bought back in 2000, because both stocks have performed poorly over the past decade, an outcome that had a lot to do with the fact that both companies carried absurd valuations.

At the outset of this article, I highlighted Tim Hanson's insight that the best-performing stocks over the past decade are small, ignored companies. Now I think we can add a couple of more qualifiers to winnow down our list:

1. Small, ignored companies.
2. Reasonable valuations.
3. CEOs who own a significant chunk of stock (and preferably are founders).

Are there companies out there that fit the bill? You bet. Jinpan International (NYSE: JST) and National Presto Industries (NYSE: NPK) -- small-cap companies in power equipment manufacturing and diversified manufacturing, respectively -- have CEOs who own 15% or more of the company's outstanding shares. The stocks are also trading at attractive valuations now.

One piece of your investing puzzle
Of course, the flip side to the world of small caps is that they tend to be more volatile and don't have the battle-tested businesses that their larger counterparts have. That's why it makes sense to spread out your portfolio among both larger companies -- for their stability and safety -- and smaller companies -- for their home-run-hitting potential.

The Motley Fool's Million Dollar Portfolio newsletter does exactly this. The investing team at MDP has built a real-money portfolio by snagging the very best picks from the whole spectrum of Motley Fool newsletters -- including the small-cap specialists. Want to learn more about MDP's approach to finding home run stocks while maintaining a wisely diversified portfolio? Just click here and enter your email address.

Fool contributor Matt Koppenheffer owns shares of Johnson & Johnson, but does not own shares of any of the other companies mentioned. Green Mountain Coffee Roasters and Hansen Natural are Motley Fool Rule Breakers recommendations. Jinpan International is a Motley Fool Hidden Gems selection. Johnson & Johnson is a Motley Fool Income Investor choice. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Bally Technologies, Contango Oil & Gas, ExxonMobil, and Johnson & Johnson. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool's disclosure policy likes sports metaphors as much as the next investor.