348 Incredible Companies

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 January 1997 through December 2006, 348 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 348 stocks, 325 of them were small caps 10 years ago. That's more than 93%. While the companies run the gamut from homebuilder D.R. Horton (NYSE: DHI  ) to oven maker Middleby, the common thread is size.

Ten years ago, D.R. Horton was a tiny $350 million company. In 10 years time, it grew to $7 billion (though recent operational difficulties have cut that number in half). Middleby grew from its $53 million valuation to $1 billion, rewarding shareholders along the way.

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, clear competitive advantages, and impressive and improving returns on equity and assets. Since we recommended it in our Motley Fool Hidden Gems small-cap investing service, it has also returned more than 700% for our members -- but we're confident it will keep on performing over the long term.

Big stocks for smaller returns
Only 23 mid- or large-cap companies would have given you the same growth, a small group that includes Capital One (NYSE: COF  ) and Danaher (NYSE: DHR  ) . And while the returns have been incredible from these firms -- both of which demonstrated some key traits of great small caps -- 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 $53 million to $1 billion, Capital One grew from a $2.4 billion valuation to $32 billion. While Capital One added substantially more value in absolute terms, the story changes when it comes to stock prices and percentages. Middleby stock returned more than 1,500%; Capital One returned 540% (because the company was bigger and because it substantially diluted shareholders along the way). Now compare that with a much larger company, such as ExxonMobil (NYSE: XOM  ) or Intel (Nasdaq: INTC  ) . These financial giants added $325 billion and $10 billion, respectively, to their market caps during the same 10-year span, yet investors gained only 213% and 24%. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.

The Foolish conclusion
Small caps are one area of the market where individual investors have the opportunity to earn phenomenal returns -- but there are also pitfalls. For every one of the 348 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 like superior management and a strong balance sheet and enjoying the benefits of diversification, our small-cap recommendations have outperformed the market by 30 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.

Tim Hanson does not own shares of any company mentioned. Middleby is a Hidden Gems pick. Intel is an Inside Value recommendation. No Fool is too cool for disclosure.


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