The Mother of All Small-Cap Winners

The mother of all small-cap winners (that is, the single most remarkable small cap that made billions for its owners) is . (no need to build suspense) . Microsoft (Nasdaq: MSFT  ) !

Your grand prize, if you correctly guessed this answer in 1986, is a bank account today stacked high with millions of dollars and a smile that says so much more than "I told you so."

When Microsoft went public 19 years ago, its stock traded at a measly $0.10 a share. Mind you, that's a split-adjusted price. Microsoft has never actually traded below $10. From humble beginnings, Microsoft shares have grown more than 250 times in value, generating returns in excess of 33% every year.

For anyone who's ever put a dime in a crackpot scheme or thrown money at a company assured to be "the next big thing," Microsoft is your Holy Grail. Beginning as a mighty mite with a stellar business model and a management team with vision, Microsoft pounded out rising profits year after year.

To find the next Microsoft, we start with pattern recognition at the Motley Fool Hidden Gems newsletter. We study what made Microsoft exceptionally good, and then look for similar traits in small public companies today. There are plenty of infants poised to grow into giants over the next two decades, but it requires some regression analysis to find them.

So, the following are key patterns that will help you identify winners among small-cap companies. It will require doing some homework, but unlike the work your third grade math teacher gave you, this could make you filthy rich.

Pattern No. 1: New industry, youthful leadership, investor skepticism
The first pattern concerns youth and skepticism. Find a small company in an up-and-coming industry with young leaders who investors either don't care about or don't believe in. Back in the 1980s, very few people thought much of the software industry. Far fewer felt that Microsoft could compete against the likes of IBM (NYSE: IBM  ) . That kept Microsoft's stock low relative to the company's very high growth rates.

Why did so few believe? Because the company was run by an extremely young management team, for one thing. Just take a look at the management team that launched Microsoft. At first glance they seem barely capable of running a lemonade stand, let alone launching and managing a company destined to become one of the world's most dominant and valuable firms, worth $275 billion today. Youthful management teams -- Google (Nasdaq: GOOG  ) or Blackboard (Nasdaq: BBBB  ) , for example -- have gained much more acceptance in the three decades since Gates & Co. started Microsoft, in no small part due to the trail their incredible success blazed.

Pattern No. 2: A long history, patient leaders, high insider ownership
If you think yourself incapable of finding that first pattern, stay in the game. Find a company with years of history and a leadership team with a huge stake in the business.

Finding the next Microsoft gets a whole lot easier when you learn that before going public, the company had been in business for a decade. We're not talking about a fly-by-night operation. Microsoft's leadership team had demonstrated patience and an inclination to be very methodical in building out the business, year after year.

The second thing management had was a gigantic equity stake in the business. You wouldn't trust a cook who didn't feast on his vittles, so why trust a management team that doesn't have a big stake in the business? At Microsoft, insiders owned more than half of the company when it came to the public markets. They had a massive stake in creating an enduring successful enterprise.

Pattern No. 3: A beautiful balance sheet created by focus
The third pattern has to do with efficiency and effectiveness. Find a company that demonstrates operational focus resulting in a sterling balance sheet.

Left out of many of the debates about the early battle between Microsoft and Apple (Nasdaq: AAPL  ) is the fact that Microsoft ran a tightly focused business. Apple did not. Microsoft knew its strength was in software. Just software. Conversely, Apple put its finger in every pie it could find: building computers, designing motherboards, and programming the core applications. It simply couldn't keep up with Microsoft's complete focus on building a business around software. How could it? Apple was too busy trying to control every element of its customers' computing experience.

The result of Microsoft's focus was a balance sheet that would make even a slumbering accountant stand up and shout. It featured a ton of cash (and plenty more with each passing quarter) and not a dollar of debt. And Microsoft had no meaningful inventory. Hop over to the income statement where sales were growing by more than 20% and margins were rising, and you're beginning to see that maybe Microsoft's shares weren't impossible to find in the late 1980s.

Bonus pattern: It's all about you
The bonus pattern has to do with who you are as an investor. When you've found a company that matches up with our first three key patterns, think very seriously about buying shares and holding them indefinitely.

Are you capable of holding a company for 19 years? If you found the next Microsoft in its early stages, could you keep your fingers off the trading button and let the company develop? If not, you may be doomed to racking up sizable trading costs and taxes, and spinning your wheels over the next two decades. Without patience, there's no chance you'll land the next mother of all small caps in your portfolio.

Pulling it all together
Let's review. If you want to find the next small-cap winner:

  • be a super-long-term investor who searches for emerging industries about which the market is skeptical;
  • find a company with youthful managers who are fanatical about the business in part because they own a huge stake in its success; and,
  • make sure that the business is tightly focused and spins out tons of cash onto its debt-free balance sheet.

These are exactly the sort of companies that we look for every month in Hidden Gems, which is a primary reason why our recommendations have risen about 37% vs. the market's 11% gain.

The only two things that stopped people from making a fortune on Microsoft were relevant information and patience. You'll have to learn patience on your own, but Hidden Gems can clue you in on which companies have Microsoft-like qualities.

Click here to take a free 30-day trial to Hidden Gems. You'll gain full access to all of our small-cap recommendations and participate in our lively message boards. There's absolutely no obligation to subscribe. But if you do, Tom will give you a free copy of The Motley Fool's Blue-Chip Report 2005: 10 Monster Stocks for the Next Decade.

Andrew Patterson doesn't have a financial position in any company mentioned. Tom Gardner owns shares of Microsoft. The Motley Fool has an ironclad disclosure policy.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 496426, ~/Articles/ArticleHandler.aspx, 12/21/2014 5:07:32 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement