Where can the hidden value in Apple (Nasdaq: AAPL ) be? Some 22 million shares trade hands each day. At least 43 Wall Street analysts -- not to mention every punter from here to Timbuktu and your Aunt Ethel -- interpret the meaning of CEO Steve Jobs' every pause and sigh.
And the experts, professional and amateur alike, have combed every SEC filing and patent application to glean the slightest prediction of Apple's next product. The iTV? The iGrill? What was that rumor about David Hasselhoff coming out of Apple's Cupertino HQ?
One of the secrets of investing is to look where no one else is looking. Sure, handicapping Apple's next product is fun and all, but it's not likely to give you an advantage over the market. And that's exactly what you need if you want to generate outsize returns. Adding a dose of small-cap stocks to your portfolio can really juice your performance.
Buy the untouchables
Finance researchers Eugene Fama and Kenneth French discovered that one in eight small-cap growth stocks becomes large every year. According to these researchers, such soon-to-be big companies return on average up to 62% annually, The Wall Street Journal notes.
With such achingly good returns, why would Wall Street shun these small caps?
In large measure, it has to do with Wall Street's deep pockets. The investment houses have to focus on the biggest and most liquid names, like Altria, Apple, Bank of America, and Citigroup. They focus on stocks that trade up to hundreds of millions of shares a day so that they can shuffle in and out of positions rapidly. Compare that to small caps, many of which trade fewer than 50,000 shares, and have market caps in the millions instead of billions. Because the Street is unable to take positions in many small caps, it also doesn't provide much research coverage.
Their tiny size and low volume mean that small caps are untouchable for most of Wall Street. Still, some mutual funds do fish for big-time winners in the small-cap pond. But just when those stocks are poised for breakout gains, the funds usually have to sell because owning larger stocks violates their charters.
For example, in 1983 T. Rowe Price's New Horizons fund sold a position in Wal-Mart (NYSE: WMT ) that would now equal $14 billion, or twice the value of its whole portfolio, if it had only held on. Ironically, the retailing giant's sales growth slows just as Wall Street becomes more interested in the company, as you can see in the table below. And Wal-Mart sales will only slow further as it expands its reach.
The New Horizons fund had a similar experience with Starbucks (Nasdaq: SBUX ) and had to forfeit a potential $200 million gain. The sales growth of companies that have risen to become today's household names has slowed remarkably. And their stock returns (though in Starbucks' case nothing to sneeze at) have slowed considerably from their heady growth days.
Annual Sales Growth
Annual Sales Growth
Annual Stock Gain 2000-2010
|Home Depot (NYSE: HD )||30%||6%||(7%)|
*Starbucks growth from 1991-2000.
But, for the same reason that it's so much fun to speculate on what marketing trick Apple is going to perform next, it's also psychologically difficult to buy small caps that you've never heard of. Humans are social -- we like to do what others are doing and we like to talk about it.
But that impulse can really kill your returns and prevent you from finding the next home run stock. It's too easy to buy the stocks that your friends or colleagues are buying. It's much easier to do what the crowd does and fail, than it is to do something different, such as buy small caps, and succeed.
Here's the opportunity
For all these reasons, you need to add the market's hidden gems as part of a diversified portfolio if you want outsize returns. To find such small caps, look for the following qualities:
- Generous free cash flows.
- Heavy on assets, light on debt.
- Dominant position in a profitable niche.
- Intelligent, driven, yet not-too-flashy management teams.
- Executives with significant personal stakes in the business.
Strong free cash flow shows that the business can bring high levels of actual cash into the business, not just book earnings and never quite collect them. A debt-light position means that a small cap has the financial flexibility to navigate tough economic times. By being a large operator in a niche market, small companies can generate outsize profits without attracting competition from large caps. Managers with "skin in the game" help align their interests with ours, and their passion and drive for excellence mean they're looking to maximize their wealth (and ours!).
Those are the criteria that the team at Motley Fool Million Dollar Portfolio uses when selecting small caps for its real-money portfolio. Below are a few companies that meet those requirements, one of which is a Million Dollar Portfolio choice.
Debt to Equity Ratio
Return on Equity
|Boston Beer (NYSE: SAM )||0%||15%||25%||33%|
|Buckle (NYSE: BKE )||0%||22%||33%||44%|
|Yongye International (Nasdaq: YONG )||1%||31%||21%||24%|
Source: Capital IQ, as of Oct. 20, 2010.
Because they're so profitable, companies like those listed above are ripe for gains. Boston Beer produces the well-known Sam Adams line of craft beers, and has managed to grow earnings for five years at a compound rate of 22%. Buckle is a retail chain that has grown net income nearly 26% annually over the last three years. Yongye -- a Million Dollar Portfolio selection -- makes a special organic fertilizer that has allowed the company to boost earnings 80% annually over the last two years. You can't get that type of sustained growth out of large caps.
If that sounds attractive to you, consider joining us at Million Dollar Portfolio. If you'd rather see which companies have already made the cut, simply click here to enter your email address and learn more.
This article was originally published April 22, 2010. It has been updated.
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.
Jim Royal, Ph.D., owns shares in Bank of America and Yongye. Home Depot and Wal-Mart are Inside Value recommendations. Apple, Boston Beer, and Starbucks are Stock Advisor picks. Yongye is a Global Gains choice. The Fool owns shares of Apple, Wal-Mart, and Yongye. The Motley Fool has a disclosure policy.