The best stocks of the past 10 years all started small. That's documented fact, and it's something any investor putting together a portfolio should know.
But as many readers have pointed out, that fact is also backward-looking. Fools want to know what the best stocks of the next 10 years will look like.
I'm no soothsayer, but I'll give it a college try ...
Far be it from me to shun the lessons of history, so I'll go out on a limb and predict that the best stocks of the next 10 years will start small -- as in a market cap of a few hundred million or less. Of course, if we take the world's major exchanges as our oyster, that means we're looking at more than 11,000 prospects.
In other words, it's not a big help, I know.
Of course, any tiny company that aspires to greatness will need some significant tailwinds. A recent business trip gave me quite a few insights into a true hurricane-force gale.
We're live from the center of the storm, Bob
Small companies with big opportunities can be difficult to come by in the United States. That's because our economy is mature, and many industries are dominated by one or two large-cap players. In automobiles, it's all about Toyota (NYSE: TM ) , Ford (NYSE: F ) , and General Motors (NYSE: GM ) -- with a host of other large companies duking it out over table scraps. And Vonage (NYSE: VG ) has found out just how hard it is to compete with Verizon and AT&T (NYSE: T ) .
Any company that wants to make inroads in these industries has some high hurdles to clear.
Where large-cap industries are dominated by small-cap companies
But that's not so much the case in a little country called China. Maybe you've heard of it. For a long time, the Chinese economy was the enterprise of the state. And though it's been liberalizing lately, many sectors remain closed to foreign companies.
This has a created an enormous opportunity for small Chinese companies to take hold in newly private niches. And while the China story has been going on for years now, it's still young. As Roth Capital's Gordon McBean told us during our visit to the firm's office in Shanghai, "It's not the seventh inning. It still feels early."
But investing in Chinese small caps isn't necessarily a risk-free proposition. There's information risk, execution risk, and the risk that corporate governance over there won't ever be up to snuff.
Will you pay to play?
While you would have paid a premium to take on those risks last year, the recent severe drop across Chinese stocks has left many previously expensive stocks on sale. Of the 135 Chinese companies listed on our major U.S. exchanges, 79 now have a price-to-earnings ratio (P/E) less than the S&P 500's -- including some better-known names such as China Security & Surveillance (NYSE: CSR ) and Cninsure (Nasdaq: CISG ) .
And while certain risks explain the new discount on these shares, as Roth Capital noted in its recent report on the Chinese economy, China has the world's best economic growth record -- posting 9.7% annual growth over the past 26 years. More importantly, that growth is expected to continue as urban migration and the development of western China roll onward.
Not much of a riddle
What do you get when you combine the world's fastest-growing economy, entrepreneurial small companies, new lower stock prices, and a political environment that in effect incubates these companies? A recipe for remarkable returns.
But don't just go throwing money in blindly. That's how you'll get wiped out when growth slows and competition increases.
Instead, focus on finding the best-run small Chinese companies that are also operating within the widest niche-market opportunities. Roth Capital's McBean has some tips:
- Steer clear of companies with government-run ownership structures. They won't be entrepreneurial enough.
- Don't invest in companies that compete against government-run companies. It won't be a level playing field.
- Keep tabs on the five-year plans the government releases. The Chinese government is efficient when it comes to achieving these goals. Seek out the companies that will help the government make its plans happen.
- Look for companies that will benefit from increasing consumer affluence. The Chinese are getting richer, and they're looking to spend on luxuries such as travel, designer clothes, and nicer homes.
Get your Chinese small caps
While these tips are specific to investing in China, you also don't want to forget your investing fundamentals. That means doing a thorough background check on a company's management, and careful valuation work to make sure you don't overpay.
Motley Fool Global Gains advisor Bill Mann and our team recently returned from another research trip to China, where we met with promising companies that fit this model. You can get all of our updates from that trip, and look at the international stocks the service is recommending today, by joining Global Gains free for 30 days. After all, you don't want to miss out on one of the best stocks of the next 10 years.
This article was first published on June 18, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. The Fool's disclosure policy knows no bounds.