Small-cap stocks sure have been bounced around this year. The Russell 2000, the leading index for small-cap stocks, was down more than 11% at one point, then it hit all-time highs over the summer, and is now back up about 6% for the year. 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, they have proven that the best way to build wealth is to hold on for years after the first new highs have been hit.
Take a look at a company like Adobe Systems. The software publishing firm went public in 1986. The market collapsed a year later, and Adobe's market cap was cut in half. Yet the small cap 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 features the following traits:
- Devoted leadership
- A sound balance sheet
- Early dividend payments
- A wide market opportunity
- A broken stock price
Lest you imagine that Adobe Systems is an isolated example, look at the commercial characteristics and investment returns of American Eagle Outfitters (Nasdaq: AEOS ) , Outback Steakhouse (NYSE: OSI ) , Cheesecake Factory (Nasdaq: CAKE ) , K-Swiss (Nasdaq: KSWS ) , and THQ (Nasdaq: THQI ) . Each suffered numerous 30% to 50% declines in the journey from small to large cap. Yet 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 favorite small-cap companies now by taking a free trial to Motley FoolHidden 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 and lead analyst of Motley Fool Hidden Gems. Tom does not own shares of any company mentioned in this article. The Fool has adisclosure policy.