The Case Against Small Caps

It took me nearly 20 years to grasp the implications of what I'm about to tell you in the next few minutes.

Now, the case against small caps
Yeah, yeah ... we know all about those lucky devils who retire at 35 after stumbling upon a Dell (NASDAQ:DELL) a decade ago or a Wal-Mart (NYSE:WMT) a quarter-century ago -- before they hit the big time.

But that sword cuts both ways, right? What about the thousands of less-fortunate chumps who get wiped out when their small-cap wonders suddenly go belly up, leaving them holding the bag?

Isn't that the "problem" with small-cap stocks, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School and that's what they'll teach you (though remember to pack a few hundred thousand in small bills). Or you can save a few bucks and consider something else instead. What if the problem isn't with small-cap stocks, but with small-capinvestors?

What if, maybe -- just maybe -- it's because they're so darn explosive that small-cap stocks are like magnets to gamblers and daredevils? Maybe it's this congregation of reckless spirits -- just dying to roll the dice for a shot at the next big thing -- that creates the illusion of a wacky and treacherous market.

Maybe nothing. That's precisely what happens. And you don't have to take my word for it. In fact, reams of data support that very contention; I'll even show you some in a bit. But more important than any piece of data is how you can use this "illusion" to make money.

First, why small-cap investors get creamed
At Harvard, slip the dean that first 50 grand or so, and they'll let you in on why small-cap stocks are risky. Markets for smaller stocks are illiquid, they'll tell you. Earnings are less dependable and uneven ... capital is more costly and hard to secure, especially when times get tough.

But none of that is the real reason why small-cap investors get pummeled. It's more insidious than that. It's because they don't invest -- they speculate on stock tips and super high-risk story stocks with low-quality (or worse, no) real earnings. It's that simple.

Small-cap investors ignore fundamentals. At least, too many do. If you don't believe me, ask yourself this: When was the last time you heard somebody hocking a small-company stock at a party or on TV, and the fellow wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that to the stodgy value investors who focus on mature large-cap, cigar butt, and smokestack companies trading at bargain prices. Could these guys possibly be more boring? They hardly ever talk story. They're all balance sheets, assets, cash flows, and, worst of all, valuation.

Sure, they're smart. Smarter than me, but they don't earn their maximum potential, either. Why? Because they're too busy picking over Wall Street's large-cap scrap heap. You can beat the market with fallen angels like these, but let's face it: Their doubles and triples are behind them.

The trick, obviously, is to apply these old school techniques -- "secrets" passed down by legendary value hounds like Ben Graham and Warren Buffett -- to America's best up-and-coming small companies. Again, I know it sounds simple, but you'd be amazed how few investors even give it a shot.

Forget the "next home run stock"
If you're a regular here (and if you're not, hello and welcome), you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with a handful of legendary fundies like Chuck Royce and David Nierenberg, Tom and his crew at Motley Fool Hidden Gems are among the few I know who are cashing in on this little "trick."

This little trick, of course, is shunning "the next big thing" in favor of legitimate small businesses with strong fundamentals at reasonable prices -- in other words, small-cap value. Put another way, these guys consistently make money in small caps (you'll see how consistently in a bit) by balancing "story" and "potential" with fundamentals and valuation.

This is what led investors to Wal-Mart in the '70s and turned a $5,000 investment into $2.5 million. What did Wal-Mart have 30 years ago that some of today's little wonders don't? Let's take a look at how 1975 Wal-Mart compares with some of today's most heavily traded small caps:

While Wal-Mart boasted rapidly expanding profits and revenues back in 1975, that's not the case at the five companies I just showed you, which have no profits to speak of. Moreover, three of the five are struggling to grow revenue.

Companies like that are all story. And while speculating on them could work out in the end, it's a long shot. The safer bet is to find small caps like Wal-Mart that can make you a lot of money methodically over the years.

After all, this "trick" turned $1,000 into $30 million
Granted, it took 70 years to do it, but still. And that's according to Ibbotson Associates, a firm that's been collecting market data for nearly a century. According to Ibbotson, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps. And more than 15 times better than if you'd bought large caps (the stocks everybody loves) instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for just a couple of years now, but take a look and judge for yourself.

Over the past few years, Tom has alerted his subscribers to more than 50 small-cap value stocks. More than half a dozen of those picks have doubled in value or more, and the portfolio is up on average 39%. That's compared to 13% if you'd bought the S&P 500 instead.

Now, for the really good news
You don't have to pay Harvard to find these market-thumping stocks (honestly, I don't know why I'm harping on Harvard today, though I wouldn't rule out envy). Heck, you can get Ben Graham's Security Analysis at the library, if you're up for poring over 700 pages. Or you could click around Fool.com for an afternoon.

But you know what I would do? I'd try Hidden Gems free for 30 days. You get full access to the entire Hidden Gems service for an entire month (including the stock scorecard and every single back issue), and there's no obligation to subscribe. This way, no matter what you do with the rest of 2006, the first lesson is on Tom. Click here to see how easy it is.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all Tom's picks on his Scorecard with yourfree trial. Paul doesn't own any of the stocks named here. Dell is a recommendation of both Stock Advisor and Inside Value. The Motley Fool has adisclosure policy.