The 10 best-performing stocks of the past decade were obscure, ignored, and small. But what about the top 25? The top 50? The top 100?
It turns out that most of the stock market's greatest performers of the past 10 years were also obscure, ignored, and small.
Small stocks for big returns
From June 1996 through June 2006, 308 stocks could have earned you greater than 20% annualized returns over the past 10 years -- turning a $10,000 initial investment into more than $60,000. Of those 308 stocks, 285 of them were small caps 10 years ago. That's more than 90%. While the companies run the gamut from technology firm Citrix Systems (Nasdaq: CTXS ) to food-service equipment manufacturer Middleby, the common thread is size.
Ten years ago, Citrix was a $965 million company. Today it's worth $6.4 billion. Middleby has grown from $91 million to $640 million.
And Middleby, for one, is still growing. The company dominates its niche and has almost every trait investors should look for in a small cap: superior leadership, a clear competitive advantage, and simply mind-boggling returns on capital -- more than 25% over the trailing-12-month period. As a three-time recommendation in our Motley Fool Hidden Gems newsletter, it has returned 20%, 70%, and 340% for our members.
Big stocks for smaller returns
Only 23 mid- or large-cap companies would have given you the same growth, and they're the cream of the crop: Progressive (NYSE: PGR ) , Adobe Systems (Nasdaq: ADBE ) , and Dell (Nasdaq: DELL ) , to name three. And while the returns have been incredible from these companies -- each of which demonstrates some key traits of great small caps: strong financials, strong competitive position, determined leadership -- they're just not as prevalent as the small guys.
That's because it's difficult for larger companies to generate the same kind of growth as small caps. While Middleby grew from $91 million to $640 million, Adobe grew from a $2.6 billion valuation to be worth $17.7 billion. While Adobe added substantially more value in absolute terms, the story changes when it comes to the stocks' percentage gains. Middleby returned 600% to shareholders; Adobe returned 580%. Now, compare that with a much larger company such as Citigroup (NYSE: C ) . The company added $230 billion of value during the same 10-year span, but that increase resulted in just 360% gains for investors. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.
Small caps are one area of the market in which the individual investor has the opportunity to earn phenomenal returns, but there are also pitfalls. For every one of the 285 small caps that could have earned you greater than 20% annualized returns over the past 10 years, quite a few more didn't make it. Small-cap stocks tend to carry considerably more risk than large caps, so investors must consider their investments very carefully.
That's why we advocate a diversified portfolio of select small caps for Hidden Gems subscribers. By focusing on factors such as superior management and a strong balance sheet and enjoying the benefits of diversification, our small-cap recommendations have outperformed the market by more than 17 percentage points since we started.
Every investor should have at least some smart exposure to small caps, because the historical profits are just too good to pass up. If you'd like some help getting started in this incredible area of the market, click here to join our community free for 30 days.
This article was originally published on Feb. 6, 2006, as "325 Incredible Returns." It has been updated.