Let's Find the Next 60-Bagger

Small-cap stocks sure have been bounced around this year. Back in April, the Russell 2000 -- the leading index for small-cap stocks -- was down more than 11% year to date, but it has since screamed up to all-time highs. Yes, the Russell 2000 is higher than it was in early 2000, before the stock market crash. Is now the time to expect a quick reversal? Should you book profits now, afraid of the next downturn? Let's be contrary: Abandon emotion and, instead, study history.

Master investors who've used market declines to build out their positions in great companies have accumulated enormous wealth. When valuations collapse, they don't run for the hills; they run in from them to buy more. And instead of trying to time the market with a quick sale, their results suggest strongly that the best way to build wealth is to hold on for years, well after their stocks first hit new highs.

Take a look at Adobe Systems. The software publishing firm came public in 1986. The stock market collapsed a year later, cutting Adobe in half. Yet the small-cap company had a super-strong balance sheet, dedicated leadership, and a widening market opportunity.

Now here we are 19 years later. Adobe is still supervised by its two founders, John Warnock and Charles Geschke. Over these intervening years, the stock has fallen 50% or more on six separate occasions. There've been numerous short-term periods when owning Adobe felt like a magnificent mistake. Heck, from September 2000 to September 2002, Adobe dropped 75% as technology stocks were sold indiscriminately.

Yet over these 19 years, Adobe Systems has risen 60 times in value, turning a $10,000 investment into $600,000. That amounts to 25% yearly growth with taxes deferred. It's a market-crushing return, a thing of beauty that doesn't even include the dividends it began paying out back in 1990.

This is exactly the sort of business we stalk in Motley Fool Hidden Gems, as it featured the following traits:

  1. Devoted leadership
  2. A sound balance sheet
  3. Early dividend payments
  4. A wide market opportunity
  5. A broken stock price

Lest you imagine that Adobe Systems is an isolated example, look at the commercial characteristics and investment returns of Aon (NYSE: AOC  ) , Limited Brands (NYSE: LTD  ) , Genzyme (Nasdaq: GENZ  ) , Boston Scientific (NYSE: BSX  ) , Costco (Nasdaq: COST  ) , or BlackRock (NYSE: BLK  ) . Each suffered numerous 30% to 50% declines in the journey from small to large cap. Yet with dividends reinvested, each absolutely crushed the market's return over the past 10 to 30 years.

We've found a number of these companies. And so it only makes sense that we're pleased as pudding by the opportunity to add to them when the market declines, and we're more than willing to hold onto them when the market is up. You can view my 20 favorite small-cap companies now by taking a free trial to Hidden Gems with no obligation to subscribe.

This article was originally published on May 9, 2005. It has been updated.

Tom Gardneris co-founder of The Motley Fool, which is investors writing for investors. Costco is a Motley Fool Stock Advisor recommendation. The Fool has adisclosure policy.


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