Stocks That Jump the Shark

Here's the interesting thing about the best small companies on the public markets: If they are truly superior businesses, they're not small caps for long.

When good stocks go big
When Microsoft (Nasdaq: MSFT  ) went public in 1986, its market cap was less than $1 billion -- a classic small cap by today's standards. Very early and very happy investors have made tremendous profits since then -- to the tune of 35% annualized returns. But they no longer hold a small company. With Microsoft now capitalized at $288 billion, they hold a "megacap."

By my count, it's one of nine such "megacap" companies. You've no doubt heard of a few of the others: ExxonMobil (NYSE: XOM  ) , General Electric (NYSE: GE  ) , Procter & Gamble (NYSE: PG  ) , and Bank of America (NYSE: BAC  ) .

The market-cap breakdowns are mutable and relative, sure -- who, after all, wouldn't count Johnson & Johnson (NYSE: JNJ  ) and its $190 billion market cap as "mega"? -- but as approximations, they're useful for a portfolio checkup. Here's a quick refresher:

Classification

Market-cap range

No. of such companies on today's market*

Mega caps

$200 billion and greater

9

Large caps

Between $10 billion and $200 billion

535

Mid caps

Between $2 billion and $10 billion

961

Small caps

Between $300 million and $2 billion

2,322

Micro/nano caps

Less than $300 million

3,029

*Data from Capital IQ.

News flash: The stocks that will jump the shark aren't already sharks
There's an odd paradox at play here. Wall Street is forced to follow larger companies, which means the pros mostly focus on less than one-fourth of public companies on the three major U.S. exchanges.

The remaining 78% of companies are largely ignored by the Street. But that should be good news to you -- that 78% is where the market's best performers come from.

But don't feel sorry for Wall Street -- and be careful in small-cap land. These stocks can also be the market's worst performers.

"Be careful"? Thanks, that's helpful -- no, really, thanks
As you identify the stocks that have the most room to run -- the ones that will jump the shark and be megacaps someday -- abide by these five precepts from our Hidden Gems investing service:

  1. Broadly diversify.
  2. Invest new money on a regular basis.
  3. Eliminate emotion from your decision-making.
  4. Expect mistakes.
  5. Scale back any individual position, or your overall exposure to stocks, if you're fretting the volatility.

The Foolish bottom line
Keep those precepts in mind as you're searching for the winners among the small companies. If you want a cheat sheet to get you started, you can check out our favorite small companies at Hidden Gems with a free 30-day trial. All told, Hidden Gems picks are beating the market at large by more than 22 percentage points since inception in 2003.

Interested? Follow this link to take us up on the free-trial offer.

Brian Richards owns shares of Microsoft but no other companies mentioned in this article. Brian wishes he owned a bearshark. Microsoft is an Inside Value recommendation. Bank of America and Johnson & Johnson are Income Investor picks. The Fool's disclosure policy makes a mean seven-layer dip.


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