Hunting Baby Elephants

Wall Street's wizards are constantly appearing on CNBC to tell us: "You must own this," "You have to own that." Why would anyone not want a piece of Microsoft (Nasdaq: MSFT  ) , the world's most powerful software company? What excuse is there for not owning General Electric (NYSE: GE  ) and Wal-Mart (NYSE: WMT  ) , the world's largest companies by market capitalization and sales, respectively? And with all the money you pump into your gas tank every week, doesn't it make sense to buy a few shares of Exxon Mobil, (NYSE: XOM  ) the world's most profitable company, and Citigroup (NYSE: C  ) , the world's most profitable bank?

It's hard to argue with analysts who push companies like these -- obvious "greats," each and every one. But here's the problem: The more obviously great a company is, the less likely you'll be able to buy its stock for a great price. Each and every one of the above five companies sports a market capitalization in excess (several, well in excess) of $200 billion. The chance of any one of them doubling its market cap -- and your investment therein -- in the near future is remote.

Even King Kong was a cute little monkey once
But consider what might have been if you had bought these companies when they were still young. Not Exxon or GE, perhaps -- neither of those has been "young" for nearly a century. Two others of the five, however, had their beginnings within the lifetimes of many who are reading this article.

When the first "Wal-Mart Discount City" opened up its storefront in Rogers, Ark., in 1962, the company was not so much an underdog as a runt pup, beset on all sides by snarling rivals like discount retail powerhouse Kmart (Nasdaq: KMRT  ) . After surviving this dogfight for eight years, though, Wal-Mart first traded as an over-the-counter stock on Oct. 1, 1970, with shares changing hands at $16.50 a stub (about a penny a share, split-adjusted). Today, this undisputed king of retail sells for $53 per share and has a $225 billion market cap.

Microsoft, the new kid on the block by comparison, went public on March 13, 1986, at a price of $21 ($0.10 split-adjusted). Its initial $700 million market cap dwarfed Wal-Mart's market-baptismal valuation, and today, at $280 billion, it's still the bigger elephant. Its original investors, though, have seen their equity rise "only" 400 times.

Why we hunt small caps
You've probably heard by now how small caps have been outperforming large caps for far too long. That it's time to shift money into large caps because, well, I guess because it just isn't fair for small caps to do so well for so long, and they're bound to suffer by comparison to the S&P 500 sooner or later. True? False? I don't know. And couldn't care less.

Our Motley Fool Hidden Gems small-cap newsletter team didn't decide to focus on investing in small caps because they had underperformed large caps for "X" number of years. Nor because they were likely to start outperforming over the next "Y" number of years. We had and have other reasons for focusing on small caps, none of them predicated on historical trends, statistical likelihoods -- or rearview mirrors or crystal balls, for that matter.

We invest in small caps for the following reasons:

Reason #1: Clarity trumps opacity
Citigroup alone has five separate divisions within its business. Microsoft has eight. General Electric, 11. How in heaven's name can an individual investor, working a full-time job and, for some of us, spending the rest of his or her free time changing diapers and shopping for groceries, ever hope to keep track of so many moving parts? Especially when some companies seem to go out of their way to obscure, rather than clarify, how their various businesses are doing?

Simply put, small caps are just plain easier to understand. As a rule, they've got clear business models consisting of just a handful of business lines -- and sometimes even fewer. Hidden Gems recommendation CNS (Nasdaq: CNXS  ) , for example, which I've recommended a few times in the past and which is up roughly 30% over just the past two months, basically does just two things. It sells nasal strips. One. It sells dietary fiber supplements. Two. That's it, and that's a business anyone can understand.

Reason #2: Valuation matters
In his classic work, The Intelligent Investor, value-investing godfather Benjamin Graham sounded a cautionary note about small caps as opposed to their larger corporate brethren. The market generally accords smaller companies lower valuations (as a multiple of their earnings) than it will grant to larger companies -- a reflection of the perceived disadvantage that small caps have in weathering adverse economic environments.

But that general investing thesis deserves a caveat, for not all small caps are created equal. Assume the market values small-cap A the same way it values small-cap B. Further, assume that small-cap A has a balance sheet much stronger than small-cap B's and, indeed, stronger than those of many large caps. Finally, give small-cap A a sustainable competitive advantage, a business moat that protects it from small and large competitors alike.

Such are the small caps we seek out in Hidden Gems. And again, CNS fits the bill. The company has more than $50 million of cash in the bank and no long-term debt -- how many large caps can boast as much? What's more, the company has a wide and deep moat around its core product, the Breathe Right nasal strip, in the form of a 90% market share for such devices. In 1998, we saw the value of that moat when little CNS fought off attempts by drug company giant Schering-Plough to market a competing product and steal CNS's share. Long story short, CNS beat Schering soundly and sent the big dog skulking off with a tucked tail.

Reason #3: The bigger they are, the harder they fall
There's another reason we like that the market tends to underprice small-caps. The lower any company's price in relation to its intrinsic value, the shorter the distance it can fall should adversity strike. Rarely will you see a profitable company -- small or large -- selling for less than twice its cash on hand, no matter how bad business gets. Just take a glance at drug companies like Merck and Pfizer, beset by lawsuits over their respective drug portfolios. For all their troubles, both of these companies are still profitable, and both still trade for many, many times more than their net cash.

Should doomsday arrive in the form of an FDA finding that, I don't know -- wearing Breathe Right strips makes people cross-eyed -- CNS's comfy cash stash (currently making up one quarter of its market cap) should easily cushion its fall. And since Hidden Gems recommended the company when it was trading for an enterprise value-to-free cash flow ratio of just 10.1, chances are we won't have far to fall in any case.

Reason #4: Tech isn't the answer. Quality is.
One final note. Look again at that list of the world's five biggest companies again. How many of those companies are "techs"? By my figuring, even if you count GE as half-tech, a good 70% of them are just good old-fashioned, "old-economy" players.

And here's the moral I'd like you to draw from this fact: You don't have to be "tech" to get big. You get big by sticking to your knitting. By focusing on the fundamentals. By earning profits wherever they're to be found. If there's a reason why almost nobody has ever heard of 90% of the companies we've recommended in Hidden Gems, that's it. And if there's a reason we beat the market's 6% return last year by a factor of four (yep, that's 24%), then that's it, too.

We're not a stingy lot here. If you're of a mind to invest in solid companies earning real profits, regardless of whether CNBC has ever heard of them, we invite you to take a free trial of our service for one full month. If you like it, stick around for the fun as we search for the next Wal-Mart. And if you find it's not for you, you can cancel at any time. No questions asked. No strings attached. You have our word on it.

Fool contributor Rich Smith has no position in any company mentioned in this article. The Motley Fool will never give up the hunt for full disclosure.


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