The Next Home Run Stock

I assume that you, like everyone and his Aunt Audrey, would love to find the next Wal-Mart -- to dig out the market's most precious Hidden Gems. Back in October 1977, Wal-Mart traded at a split- and dividend-adjusted price of $0.05 per share. Today, it trades for around $45. In just 30 years, Wal-Mart has turned a $5,000 investment into $4.5 million.

Of course you'd love to buy the next Wal-Mart.

But you'd prefer not to take on extreme risk, right?

I think you're smart to think that way. So do a long list of great money managers -- from Peter Lynch to Seth Klarman, Bill Miller to Charles Royce. They've all searched for small companies with a mixture of sales and free cash flow growth, superior returns on invested capital, heavy insider ownership, and healthy assets -- all at a reasonable price.

Forever great
But remember, companies like Wal-Mart typically exhibit excellent financials from the day they hit the public markets. Wal-Mart was never a penny stock (again, that share price of $0.05 back in October 1977 is split- and dividend-adjusted; the stock traded at $17 back then). Wal-Mart didn't hype itself in press releases, nor did management make outlandish promises to its investors. As it turns out, if you want to find monster long-term winners, you shouldn't throw money at shaky, speculative companies.

Wal-Mart founder Sam Walton, who owned a massive stake in the enterprise, ran his company conservatively for decades. And just four years after its IPO, as a tiny public company, it began paying a dividend. This business was run to sustain yearly profit growth indefinitely. If you're going to invest in small-cap rocket stocks, as we do together in Motley Fool Hidden Gems, please avoid the whisper-stock party tips and hype jobs. They destroy wealth over time. Wal-Mart wasn't getting hyped. No one was following it!

Contrary to popular perception, you need not assume great risk to invest in the best small caps. You only need to train yourself to look for disciplined, conservatively run small businesses.

Finding these stocks doesn't involve a hopeless search through barn-sized haystacks for a lone platinum needle. The stock market features plenty of promising smaller companies, run successfully by founders with large personal stakes in the enterprise. In fact, they thrive in every industry -- electrical, education, medicine, retail, and beyond. Take a look at these five great investments from 1995 to 2007, all of which were small caps in the mid-'90s.

Nov. 21, 1995*

Nov. 21, 2007

Return on Investment

International Game Technology (NYSE:IGT)

$2.93

$41.02

1,300%

Jacobs Engineering (NYSE:JEC)

$5.78

$75.45

1,205%

Allergan (NYSE:AGN)

$6.14

$61.46

901%

Forest Labs (NYSE:FRX)

$5.24

$35.44

576%

Autodesk (NASDAQ:ADSK)

$8.17

$45.23

454%

*All prices adjusted for splits and dividends. Data from Yahoo! Finance.

Note, again, that this group hails from a broad variety of sectors. A few are familiar faces, while the others remain largely unknown on Main Street. But each was a small cap 12 years ago. And not only weren't they industry stalwarts, they were also flying below most consumers and investors' radar. They had yet to attract a cadre of Wall Street analysts and big institutional investors.

And their stock prices reflected it. They were cheap because they were irrelevant!

They're what we search for together, every day, in Hidden Gems. And these sorts of opportunities do exist today.

The next big thing
The 20- to 700-baggers of the next 12 years are out there right now, with their fuses lit and a wide-open sky above them. But they aren't Allergan, valued at almost $19 billion today. They're also not companies like Wal-Mart, valued at $182 billion, covered by 26 Wall Street analysts.

They're small companies with strong founders and executive ownership north of 10%. Companies without debt concerns. Companies that generate excess cash from their operations, some of which already pay dividends. Companies that function without any real reliance on Wall Street for financing or table-pounding "strong buy" ratings.

I know it sounds contrary, but I want you to see that many of these small businesses offer low risk and high rewards for their long-term owners. How could a small company be less risky than a giant? Ask the former owners of WorldCom. Not only was that company overfollowed, but it was also fraudulently run!

The exact opposite exists with great small caps. They're well-run and underfollowed on Wall Street, creating price inefficiencies that strongly favor long-term investors.

Does that sound possible? Does it sound logical? It's certainly contrary.

What I look for
Every day in Hidden Gems, we track down the following:

  1. Founders with large personal stakes.
  2. Financial statements that are easy to read.
  3. A solid asset base with little or no debt.
  4. Price ratios that significantly undershoot growth rates of free cash flow.
  5. Dominant positioning in a profitable niche.
  6. Plenty of room to grow.

If you're inclined to think that every small-cap stock is doomed to have a larger competitor stomp it out, I ask you to return to my list of strong performers above. Each rose from obscurity because of sound financial management and shareholder-friendly practices. The free markets gave them plenty of maneuvering room.

But because not every small company is poised for enduring success, I evaluate more than 100 of the 3,000-plus small-cap stocks each month -- all in search of one great Hidden Gems recommendation. As for the others, I find that 90% are too richly valued or too speculative, given the underlying business. That remaining 10%, however, leaves us with hundreds of small caps that will beat the market, and dozens that will rise more than 30 times in value over the next 10 to 15 years.

You can read about this, and all of our Hidden Gems recommendations, right now, by signing up for a 30-day free trial. There is no obligation to subscribe. You have my word.

This article was first published on Sept. 24, 2003. It has been updated.

Tom Gardner is co-founder of The Motley Fool, which is investors writing for investors. Wal-Mart is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.


Read/Post Comments (22) | Recommend This Article (22)

Comments from our Foolish Readers

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  • Report this Comment On November 30, 2007, at 2:14 PM, duke5522 wrote:

    I look through this artical and find nothing that tells me what the next home run stock is. seems this is just an add to buy hiden gems.

  • Report this Comment On November 30, 2007, at 2:30 PM, RVODutchboy wrote:

    This kind of advertising sucks. I'm already a subscriber. Don't waste my time.

  • Report this Comment On November 30, 2007, at 5:29 PM, Foggy15 wrote:

    paid my money for a little investing info not to read advertisements motley another blood sucking internet load of crap

  • Report this Comment On November 30, 2007, at 6:30 PM, kayakmastr wrote:

    Hey guys, First, article is not spelled artical. Second, not everyone is a subscriber. Third, it takes a second to decide to stop reading and move on, why spend the time complaining? Fourth, did you ever notice that all your newspapers, TV programs, etc are filled with advertising. Why should the web be different? Goggle soon will have advertising on your free phone.

  • Report this Comment On November 30, 2007, at 8:33 PM, spiked80109 wrote:

    I have to agree with the first couple of comments. I already subscribe. If you're going to send me an email - just include the pertinent information (in this case "Identity of the next Home Run stock") right in the email.

  • Report this Comment On December 01, 2007, at 8:58 AM, SirJimmy wrote:

    yes, i'm about to cancel my subscription. i don't want another one of your ads for other products until i feel you've delivered on the one i bought. maybe you think we think we are really getting our money's worth with this sort of marketing crap.

  • Report this Comment On December 01, 2007, at 8:58 AM, jimbingham wrote:

    Your e-mails should be titled " advertisement or solicitation". I am a relatively new subscriber to Motley Fool Stock Advisor and this is already the third such solicitation in less than a 6 week period. If this continues I probably will be a short term subscriber.

  • Report this Comment On December 01, 2007, at 9:13 AM, bridgebot wrote:

    A different form of spamming.

  • Report this Comment On December 01, 2007, at 11:27 AM, thomassherry wrote:

    I'm not thrilled with this form of hidden advertising either, even if one can eventually find the name of the stock after having clicked through two pages.

    However, I'm very concerned about the statement, "In this report, you've learned about Ctrip, a rock-solid stock that is destined to create incredible returns for savvy investors who jump onboard now."

    To me, that implies that it's a given that this stock will make me a multi-millionaire like the people mentioned in the article.

    Not good, Fool.

  • Report this Comment On December 02, 2007, at 3:14 PM, jackspratnofat wrote:

    Too Bad that I also wasted MY time on a Sunday just to read WHAT? How Wall Mart was such a Great "investment" YEARS ago. I knew that, Now please tell me something I dont know!

  • Report this Comment On December 02, 2007, at 4:57 PM, nybergdg wrote:

    I am a relatively new subscriber to Motley Fool Stock Advisor. If this spam continues I probably will be a short term subscriber. You are wasting my time reading this crap. Send this junk to nonsubscribers.

  • Report this Comment On December 02, 2007, at 8:49 PM, TxWedge wrote:

    Ditto. Y'all getting the "no more advertising" message?

  • Report this Comment On December 02, 2007, at 9:11 PM, muleshoe123 wrote:

    I paid for a service to give me research on stocks, but what I get is marketing, marketing, marketing. My time is valuable just like the other folks here.

    GET TO THE POINT!!!!!!!!

    We dont need so much lead up, page after page after page of build up. Who is it????????

  • Report this Comment On December 03, 2007, at 11:10 AM, ninetynine wrote:

    I thought my paid subscription would indeed get me more "real" articles, rather than ads and I somehow thought I did not have to subscibe to "every" newsletter, I realize now it is 200 for "each" ...kind of a lot.

  • Report this Comment On December 03, 2007, at 4:02 PM, sparksalot wrote:

    I agree there's alot of waisted time looking for something that is promised that is not there, and it's just another ad. I also subscribe already why don't you send this to non- subscriber's

  • Report this Comment On December 04, 2007, at 6:27 AM, OrchardPig wrote:

    I seem to be in the same boat with many subscribers commenting on your "shotgun" e-mail solicitations for your other services. I would think it prudent to "filter" your marketing e-mails to exclude customers subscribed to that particular service. I scan your emailings for "Gems" regularly but find these repetitive solicitations mildly irritating. I have noticed, however, that I spell somewhat better than most respondents.

  • Report this Comment On December 12, 2007, at 12:03 AM, tandy773 wrote:

    I agree with everyone here. It seems that you can't just subscribe to one newsletter, you need to subscribe to this thing and that thing, and you still get hounded to death. I think I'm reading an article that will give me more info, only to find it's an add to get me to subscribe to yet another newsletter. Sometimes it's an add for one I already subscribe to. Now, I'm trying to cancel Stock Advisor before I get charged for it, but there is no easy way to find out how to do that. Clever.

  • Report this Comment On January 01, 2008, at 12:44 PM, Gurdjeppo wrote:

    I don't feel "hounded" by the truly fake articles as others say here, but it certainly is a strange low-quality contrast to the thoughtful research and useful information found in some of the newsletters.

    This is actually the sort of service-quality dichotomy that Tom Gardener has cautioned as a sign of a company worth avoiding investing in. Honestly, it's odd that MF behaves in this way.

    I subscribe to one MF newsletter currently and I am happy with the experience—mostly the access to the boards where meaningful discourse does often happen. But I have stopped recommending MF to others because I find the obscuringly heavy load of substance-free pitch stories I know would make up the majority of their experience visiting your site to be embarrassing.

    Tom, David, please consider delivering the kind of quality you demand from your investments to you OWN customers first. If reducing the amount of advertising you sneak in front of already-paying customers means you make less money–so be it. You make p l e n t y already. It would be wiser and absolutely more Buffet-sensible to lower your operating expenses instead.

    -Gurdjeppo

  • Report this Comment On January 18, 2008, at 10:08 PM, Rafert wrote:

    I have spent the past hour trying to find out how I can cancel my Stock Advisor subscription. This subscription has been the poorest stock advice that I've ever received. And it seems that everyone else agrees too.

  • Report this Comment On May 10, 2008, at 10:52 AM, goatmandol wrote:

    Cancel Stock Advisor

  • Report this Comment On February 18, 2009, at 7:16 PM, gedawson wrote:

    Please cancel my subscription as of this date. 18 Feb. 2009 George Dawson

  • Report this Comment On November 09, 2013, at 1:23 AM, RyanPeckyno wrote:

    A little rough on the comments above. Even so, a little incongruence here and there pushes us all to new levels.

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