Be a Penny Stock Millionaire!

Our goal in Motley Fool Hidden Gems is to find the best small companies to own for the next three to 35 years. It's a wonderful aim, since historical data illustrates that small-cap stocks -- particularly of the value variety -- have substantially outperformed the overall market over the past 40 years.

To optimize our returns, we look to sell our mistakes quickly, hold sound companies for an average of three years, and then, yes, maintain our stakes in the very best of the lot for a quarter of a century or more. The best time to sell shares of a truly superior small company is almost never. Selling Coca-Cola (NYSE: KO) or PepsiCo (NYSE: PEP) in the early days after doubling your money would have wound up costing you dearly, since both continued to crush the market as the years rolled by. An investment in Coke in 1965, for example, would have doubled by 1968. But if you held on, it would have increased another 56 times in value (dividends reinvested). The same goes for Pepsi. While a 1977 investment would have doubled in five years, the stock increased another 60-fold afterward.

It's been four years, and our Hidden Gems cumulative returns thus far are gratifying. Our recommendations are up an average of 53%, while equal amounts invested in the S&P 500 over that time would have returned an average of 19%. There's no question that we'll have down periods. Recessions can be nasty for small-company stocks. But, over time, we expect to outperform the general market by buying and holding onto the next wave of great American companies.

How do we find them? Think Wal-Mart.
One way to find the future greats is to carefully study the major winners of the past. Relatively few of the multidecade superstars are technology companies. And while we don't avoid tech stocks in Hidden Gems, they are a minority of our selections. We instead favor sleepy and underfollowed companies with high-quality management. Among our sleepy, boring successes thus far are CNS, maker of the Breathe Right nasal strips (later purchased by GlaxoSmithKline), and RV parts manufacturer Drew Industries (NYSE: DW).

But for the ultimate example, think Wal-Mart.

In November 1980, Wal-Mart was trading at a split- and dividend-adjusted $0.20 per share. That's right, $0.20. But let's be clear: The stock was selling at $50 per share then, so it wasn't ever a penny stock. We think it's nearly impossible to become a penny stock millionaire -- despite the mischievous title we placed on this article. No, the greatest stocks are those of real companies, with real earnings. Because of stock splits, some investors think you'll find the next Wally World while searching among 20-cent stocks. You won't.

So what has Wal-Mart done since 1980 (a full decade after it went public)?

With the stock trading around $43.60 as of this writing, it has returned 218 times in value over the past 28 years. A $5,000 investment back then is worth more than $1 million today. That'll clean up a lot of investment mistakes!

But what if we go all the way back to Wal-Mart's IPO, when it became a public company in October 1970? The business was valued at a tiny $21.5 million then. That means the stock is up roughly 8,500 times since. That's nearly 28% growth per year, and it would have turned a $5,000 investment into $40 million today.

When the company went public, it raised $4.5 million in cash to pay down debts. Wal-Mart was nothing back then. No one knew about it. Hardly anyone followed it, while dozens flocked to Sears (Nasdaq: SHLD) and Woolworth's. None of the big boys on Wall Street really cared about it. And that plays right into Hidden Gems' sweet spot.

Reverse-engineering a superstar
Now it's time to pick out the qualities of what has been one of the greatest 25-year investments in the history of our species. Here are the traits of Wal-Mart in its early days, traits that we look for in Hidden Gems:

• After just a few years in the public markets, it began paying a dividend and never stopped -- amazing for such a tiny company.
• Related to that point, its dividend started in the teeth of a bear market in the early 1970s. That said a lot about the strength of its financials.
• Wall Street treated the company like it was a bunch of Arkansas hillbillies. For years, no analysts followed it.
• For years and years, institutional ownership was well below 50%. As we said, hardly anyone cared.
• Sam Walton owned the majority of the stock. Here was a founder with a stake in the organization's enduring success.
• Its concept was new and innovative, yet proven. Wal-Mart had been in business for eight years before going public, with more than 30 stores and over $32 million in sales on the day of its IPO.
• It had a compelling valuation, trading at just 0.67 times sales when it came public.

Find the next one
We're not trying to reinvent the wheel here in Hidden Gems, because we simply don't need to. There's something on the order of 100 years of researchable history of the U.S. stock markets and tons of data available over the past 25 years. The Internet makes much of the research relatively quick and easy.

There are also numerous masters who have shared fully formed ideas on how to earn extraordinary returns in small caps -- from Peter Lynch to Charles Royce to Warren Buffett to Martin Whitman. By combining our research capabilities with the outstanding principles these folks have handed down, we can do a lot together to increase your wealth over the long term.

And so, this is the aim of our Hidden Gems community every day, with thousands of members working together and examining the more than 7,000 public companies capitalized at less than $2 billion. We see the early outperformance in the long-term charts for eBay (Nasdaq: EBAY) and Gap (NYSE: GPS) (rocky though it's been), and we study their early history. We have no doubt we'll find some of the market's major winners over the next three to 35 years. Panning for these small-cap studs is our full-time work and our mission statement.

If you'd like full access to our service for a trial run of 30 days, let us know. It's free, and there's no obligation. You can see all of our investment recommendations, with full details on each, in our search for the next Wal-Mart-like winner.

This article was originally published on Dec. 17, 2004. It has been updated.

Tom Gardner is co-founder of The Motley Fool and heads up the Hidden Gems newsletter. He owns shares of Coca-Cola. Rex Moore is a Hidden Gems analyst and owns shares of eBay. Coca-Cola, Wal-Mart, and Gap are Motley Fool Inside Value recommendations. Gap and eBay are Motley Fool Stock Advisor recommendations. GlaxoSmithKline is an Income Investor pick. The Motley Fool is investors writing for investors.