The Secret of Small-Cap Success

Psychologists say that the pain of loss is three times greater than the joy of gain. Investors know this all too well. Indeed, the pain is so great because each time we purchase shares of a company, we do so with visions of hefty returns dancing in our head. We buy companies that look great on paper because of growing market demand, rising return on equity, accelerating sales, and so on. When our hopes get dashed, it hurts.

In Motley Fool Hidden Gems, we've been looking closely at our losers so that we can learn from them. And we're coming to thoroughly understand the guidance of master investors: Study the numbers closely, but then look beyond them. You must understand the qualitative side of investing to earn super-monstrous returns. And the most important "unquantifiable," as we've learned, is management integrity.

Recall these words from master investor Warren Buffett: "There was a guy, Pete Kiewit in Omaha, who used to say he looked for three things in hiring people: integrity, intelligence, and energy. And he said if the person did not have the first one, the latter two would kill him. Because if they don't have integrity, you want them dumb and lazy." When you invest in a company, you're taking an ownership stake in a business -- effectively hiring its executive leaders. Their work on your behalf, for better or worse, will determine the outcome of your investment. And if they lack integrity but are brilliant and passionate, they'll excel at taking your money from you!

Management gone astray
A few years back, KrispyKreme (NYSE: KKD  ) was by all accounts one of the strongest brands in America. Its donuts were a consumer favorite, and its "Hot Donuts Now" neon signs were fast becoming a fingerprint across America. A cursory glance at Krispy Kreme's filings would not have told you that severe financial trouble was ahead. Revenues nearly doubled from 2000 to 2002 and diluted earnings per share rose more than 200%. This business looked like it was on autopilot.

Unfortunately for Krispy Kreme shareholders, the team leading Krispy Kreme was too intelligent, energetic, and greedy for its own good. The company expanded too fast and then paid millions of dollars to bail out underperforming franchises -- some of which a few of the executive leaders owned positions in! Rather than admit to expansion mistakes, former CEO Scott Livengood and his team made some crafty accounting moves and overpaid to try to hide previous bad decisions. The SEC is now involved, and the end of Krispy Kreme (in its current form, at least) seems near. That's not the kind of management team that will help you achieve the superior long-term returns we seek at Hidden Gems.

More management shenanigans
Yet no investor is immune to the destructive consequences of bad management. Three of the worst-performing companies we've highlighted for Hidden Gems subscribers have been dumped by the market because of management concerns: DHB Industries (AMEX: DHB  ) , iMergent (AMEX: IIG  ) , and RedEnvelope (Nasdaq: REDE  ) .

DHB Industries CEO David Brooks has repeatedly put his own interests first -- at the expense of DHB shareholders. After selling a significant number of his shares in December at prices north of $20, he had the board issue him 5.25 million warrants to purchase shares for just $1. That kind of management will make for a stock market disaster, regardless of the strength of its product (body armor). We never made DHB a formal recommendation, but it never should have made our Watch List, either.

iMergent is now restating revenue all the way back to 2002 for not complying with generally accepted accounting principles (GAAP), and on Oct. 24 the SEC announced a formal order of investigation -- a clear sign that something is not right. The company used accrual-based accounting to spruce up its financials, meaning that it was reporting revenue when it agreed to a sale, not when it actually received the money. So instead of earning $0.37 per share in 2002, iMergent's earnings were in the range of a $0.16 loss to a $0.03 gain -- a potentially $3 million difference. That's the kind of issue that can destroy investor confidence and sink a company, despite its position as a leading small business software provider.

And then there's RedEnvelope, the only one of this triumvirate that became a formal recommendation. The problems at RedEnvelope don't quite compare with those at DHB and iMergent; there are no egregious compensation practices and no formal SEC investigations. RedEnvelope has just been a bit sloppy. The company briefly delayed filing its 10-K because its accounts payable liability was overstated (not at all a bad thing). But that hiccup came on the heels of the company blaming "weather conditions" for approximately $1.5 million worth of delayed and undelivered sales in the last holiday season. Volatile small caps can't afford missteps, and RedEnvelope stock is down approximately 6% since we recommended it two years ago -- after being down nearly 50% at one point.

The Foolish takeaway
These mistakes have made us concentrate more and more on integrity of management as an essential aspect of our analysis. We seek honest leaders atop superior businesses that will maximize shareholder value at each and every turn. These are people like Jim Sinegal at Costco (Nasdaq: COST  ) and John Mackey at Whole Foods (Nasdaq: WFMI  ) -- two companies that boast 10-year annualized returns of 18% and 37%, respectively.

These are the folks investors can follow to brighter financial futures. We've found one in Leigh Abrams, CEO of May 2005 Hidden Gems pick Drew Industries (NYSE: DW  ) . We've been impressed by Abrams' candor, knowledge, and honesty -- in fact, Drew's corporate governance practices outranked 98% of the Russell 3000 in 2004. The company's stock is up nearly 60% since we recommended it, but more impressively, it's returned 23% per year for the past 10 years.

There are many more great leaders in the 50-plus other companies we're following, and our recommendations are currently beating the market by nearly 20 percentage points. If you'd like to join us as we hunt for tomorrow's great companies a day early, click here to take a no-obligation 30-day free trial. You'll have access to all of our buy reports and all of the investing lessons we've learned, as well as to the Hidden Gems dedicated discussion boards, where thousands of subscribers help keep tabs on the management teams and metrics at all of the companies we highlight.

Most investors want to conceal their biggest mistakes. But we want you to know what we've done wrong in the past because learning from mistakes is the best way to achieve future success. That's why integrity of management is near the top of our checklist for finding superior long-term investments. And if we can sniff out one dud before it makes it into your portfolio, well, our returns will be that much better along the way.

Fool on!

Motley Fool co-founder Tom Gardner is the lead analyst of Motley Fool Hidden Gems. Tom does not own shares of any company mentioned in this article. Motley Fool researcher Tim Hanson owns shares of Whole Foods. Whole Foods and Costco are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.


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