The Case Against Small Caps

Have you heard the one about young Larry Ellison's nosy neighbor who bet the ranch on Oracle (NASDAQ:ORCL) in 1990, sold the stock and retired 10 years later?

It's the oldest story ever told. Back in the day, it was a poker pal of old Walt who made a killing on Disney (NYSE:DIS). However you tell it, it's a fun story.

But that sword cuts both ways, right? After all, what about the less-fortunate chumps who get wiped out when their hot stock tip suddenly goes belly-up, leaving them holding the bag? Isn't that the "problem" with buying lesser-known companies, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School, and they'll tell you the same thing. Be sure to pack a few hundred grand in small bills, though. Or save yourself some money and consider something else. What if the problem isn't with small-cap companies, but with small-cap investors?

What if the problem with small caps is that they attract the wrong crowd? Maybe it's all those gamblers and daredevils (and nosy neighbors), vying for the next home run, that creates an "illusion" of a wacky and treacherous market.

Don't take my word for it -- reams of data support that contention. But there's something more important than any piece of data -- how you can use this "illusion" to make money.

Why small-cap investors get creamed
Any finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to secure, especially when times get tough.

All true, but I'm not convinced that's why small-cap investors get pummeled. It's more insidious than that. It's because they don't invest. They speculate on stock tips and high-risk story stocks with low-quality -- or worse, no -- real earnings. It's that simple.

Small-cap investors -- too many of them, at least -- ignore business fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small-company stock at a party or on TV, and he wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who focus on mature large-cap, cigar-butt, and smokestack companies trading at bargain-basement prices. Could these guys be more boring? They never talk story. They're all assets, cash flows, and valuation.

That's why they don't earn their full potential, either. Sure, you could have made money on a neglected blue chip like Coca-Cola last year -- I did myself -- or by rolling the dice on a General Motors (NYSE:GM) comeback right now. But even best-case, their triples and quadruples are behind them. They're just too big.

The Holy Grail, obviously, would be to take the old-school valuation techniques made famous by Ben Graham and Warren Buffett and apply them to up-and-coming smaller companies, while their growth spurts are still ahead. Again, I know it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget "the next home run stock"
If you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with folks like Chuck Royce and David Nierenberg (who we had the pleasure of meeting here at Fool HQ recently) Tom and his crew over at Motley Fool Hidden Gems are among the folks I've seen cashing in on this little "trick."

The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals at good prices -- in other words, small-cap value. The guys I just mentioned consistently make money in small caps by balancing "story" and "potential" with fundamentals and valuation.

After all, isn't that what led investors to Wal-Mart in the '70s? They turned a $5,000 investment into $2.5 million. But how did they find it? I mean, what exactly was so great about Sam Walton's general store back in 1975? Take a look at how Wal-Mart compared with some of today's heavily traded small caps:

Clearly, while Wal-Mart was rapidly expanding revenues and profits back in 1975, that's not the case with the other companies in the table. In fact, while these companies are managing to grow revenues, they don't actually have earnings at all.

Which isn't to say they don't have potential. But you can see how they are mostly "potential." Speculating on companies like these may work out for you, but it's a crapshoot. The safer play is to dig up small caps like Wal-Mart -- when they're still small -- that can make you a lot of money methodically over the years.

This "trick" turned $1,000 into $33 million
Granted, it took nearly 70 years to do it, but according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large-company stocks instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for only a couple of years now, but judge for yourself.

So far, Tom has alerted his subscribers to more than 70 small-cap value stocks. More than a dozen subsequently doubled or more, and as of this morning, the entire portfolio is up 53.8% on average. That's compared with a respectable 19.5% if you'd bought the S&P 500 instead.

How about some really good news?
You don't have to pay Harvard to find great small-cap values anymore. You can pick up Ben Graham's classic Security Analysis on Amazon. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- and there's no heavy reading required.

You can join Tom Gardner and Bill Mann at Hidden Gems free for 30 days. This way, you can check out the complete Hidden Gems service, including all of Tom and Bill's recommendations and every back issue. Then take a whole month to decide whether you want to join.

I guarantee you'll meet lots of friendly and knowledgeable investors who love to talk stocks, and nobody will pressure you to subscribe. In other words, the first lesson is on Tom. To take advantage of this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all Hidden Gems picks on his scorecard with your free trial. Paul owns Coke, which is a Motley Fool Inside Value pick, as is Wal-Mart. Disney is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy.