Still the Secret of Superior Stocks

The best-performing stocks start small. We learned that in 2005, and we learned it again last year.

And of the 348 companies that offered greater than 20% annualized returns over the past decade, 325 were small caps 10 years ago. That 93% frequency of small caps among the market's best performers is far greater than the 74% frequency of small caps on the major U.S. exchanges overall.

But not every small cap is a great investment. That's why I wanted to know more last year. I set out to analyze the 100 top-performing small caps to see what they had in common and what set them apart from the crowd.

A money-making discovery
My study concluded that the best-performing small caps all shared a very telling trait: a dedicated management team. Fully 84 of the 100 best-performing small caps from 1996 through 2005 had a management team that either owned more than 5% of the company's shares or had been at the helm at least 10 years.

That fact was true of fewer than 50% of small-cap stocks overall.

Coincidence? I think not.

Now that another year has passed, we have another 10-year period to examine. Do our findings still hold up?

In a word, yes -- and they're even more convincing.

Among the 100 best-performing small-cap stocks from 1997 through 2006, 62 continue to be more than 5% insider-owned. This list includes American Eagle Outfitters (NYSE: AEO  ) , Daktronics (Nasdaq: DAKT  ) , Credo Petroleum (Nasdaq: CRED  ) , and Outdoor Channel Holdings (Nasdaq: OUTD  ) . Another nine companies continue to have a founder or founders who take a significant interest in the business, as either chairman of the board or CEO. And 14 more of the top 100 small caps, including Ryland Group (NYSE: RYL  ) and Stericycle (Nasdaq: SRCL  ) , have had their CEOs in place for 10 years or more -- a significant fact at a time when the average tenure of a CEO has dropped to just five years.

Still not convinced?
A dedicated management team is absolutely crucial to the success of a small company. Just think back to some of the market's greatest success stories, like Microsoft and Dell. Each was led by a founder who owned shares of his company and was absolutely committed to building the best business possible.

That one-two punch is what makes for huge returns for outside shareholders.

Action steps
So how can investors find the dedicated management teams in the oftentimes unseemly world of small-cap stocks? One way is to screen for stocks that have insider ownership of 5% or more. This methodology isn't foolproof, but it's a good way to get started.

Dividends can also be a sign of a management team that's both fiscally conservative and committed to rewarding outside shareholders. Investors can also listen to how management talks about the business and fields questions on conference calls. And if you're still not convinced, put in a call to investor relations. Unlike with large companies, prospective small-cap shareholders can actually get CEOs on the phone from time to time.

At our Motley Fool Hidden Gems small-cap investing service, we're committed to finding the best small-cap stocks with the best management teams. Through phone calls, face-to-face meetings, and in-depth research, we try to recommend only the most dedicated and shareholder-friendly management teams to our subscribers. And to date, our results are promising. Since its inception in 2003, our recommendations are beating the S&P 500 by more than 33 percentage points on average.

If you'd like to take a look at the stocks we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe, and you might just discover one of the best-performing small-cap stocks of the next 10 years.

This article was originally published on Jan. 9, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned in this article. American Eagle and Daktronics are Motley Fool Stock Advisor picks. Dell is a Stock Advisor and Inside Value recommendation. Microsoft is an Inside Value selection. No Fool is too cool for disclosure.

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