The Death of Small Caps?

Haven't you heard? Small-cap investing is done. Kaput. Finito. You can't consult the media without stumbling on a pundit calling for small caps to underperform their larger counterparts because of "disappearing valuation gaps," "tighter credit conditions," or being at the "tail end of the economic cycle."

The contrarian would suggest that if the experts are aligned against a particular position, it may be time to consider taking a counterstance. However, I'll not go down that road simply because I've got two "timing-independent" reasons not to care about what the financial media is saying.

Businesses, not asset classes
We don't recommend "small caps" simply because they're small caps at our Motley Fool Hidden Gems research service. A company's size is pretty unimportant in the grand scheme of things, and a sub-$1 billion market value does not a bargain make. Instead, we buy shares of individual businesses, seeking out specific characteristics in those businesses. When we find the truly special, we're prepared to hold for the long term. And that long-term horizon is our secret weapon (as you'll see in a moment).

But what if they're right?
Are there market cycles when one asset class does better than another? Sure. In aggregate, smaller companies tend to do better in early -- i.e., growth -- stages of the economic cycle. Toward the end (where we supposedly now sit), investors lose their nerve and pile into the safety of large caps, particularly those with dividends. But remember, we don't do asset classes -- we do businesses. Large companies are fine to anchor your portfolio. I personally believe Wal-Mart (NYSE: WMT  ) and Home Depot (NYSE: HD  ) offer compelling values, but their days of multibagger performance are done.

On the other hand, short-term small-cap "underperformance" doesn't scare me. Why? If I'm going to be putting new money into stocks for at least the next three decades, I want lower prices for those special businesses. And even better, I want to repeatedly buy more shares in quality companies, taking to heart Peter Lynch's admonition that the best stock to buy may be one I already own.

Keep your eyes on the prize
OK, great. You're buying great businesses, holding long-term, and adding more shares at advantageous prices. But how are you defining those great businesses?

Glad you asked. We scour the small-cap universe for companies helmed by smart, passionate, properly incentivized management teams, ideally with substantial personal stakes in their own companies. We look for companies generating copious and sustainable free cash from their operations, giving them lots of options for growing the business or returning excess cash to shareholders. And we seek companies that dominate their niche, no matter how boring that niche might seem to the Wall Street crowd.

Enough groundwork. Want some names? How about electronic medical record (EMR) software provider Quality Systems (Nasdaq: QSII  ) , which flourishes in a young market and generates abundant free cash, carries no debt, and has paid special dividends to shareholders in each of the past two years? Or footwear purveyor DeckersOutdoor (Nasdaq: DECK  ) , which features expert brand managers and strong cash flows? And the kicker to confound the talking heads -- nothing says you have to invest in the U.S. small caps that they're down on. Consider Mexican airport operator GrupoAeroportuario del Pacifico (NYSE: PAC  ) , which recently went public and has a monopolistic lock on its markets (it's hard to build a competing airport next door), or Chinese travel coordinator Ctrip.com (Nasdaq: CTRP  ) .

A model of success
The long-term small-cap growth story can be summarized in a case study. Twenty years ago, a small four-year-old software company went public with a market value barely exceeding $100 million. Its mission? To revolutionize processes for delivering engaging print, and later visual images, to anyone. The young co-founders were relentless in pursuit of their niche and widened their reach as they grew by deploying free cash into new business. Yet the company remained a small cap for the next seven years, and suffered several precipitous price drops along the way.

Two decades later, the co-founders (a little rounder, to be sure) continue to helm the company, free cash generation has been at double-digit margins for nearly their entire public history, and the company's products are dominant today. I'm talking about Adobe Systems (Nasdaq: ADBE  ) , a 142-bagger since its 1986 IPO.

The characteristics that made Adobe great are what we're seeking out in small caps today. Come join us free for 30 days and enjoy unfettered access to every aspect of our small-cap Hidden Gems investing service -- including research, daily updates, and discussion boards -- by clicking here. Our picks are beating the market by some 17 percentage points, and you're not under any obligation to subscribe.

Fool contributor Jim Gilliesowns no shares of any company mentioned. Deckers, Ctrip.com, and Grupo Aeroportuario del Pacifico are Hidden Gems recommendations. Wal-Mart and Home Depot are Inside Value recommendations. Quality Systems is a Stock Advisor recommendation. The Fool has a disclosure policy.


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