Be a Penny Stock Millionaire!

At Motley Fool Hidden Gems, we aim 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-century or more.

The best time to sell shares of a truly superior small company is almost never. Selling Walgreen (NYSE: WAG) or Kohl's (NYSE: KSS) in the early days, after doubling your money, would have wound up costing you dearly. Both continued to crush the market as the years rolled by. A January 1982 investment in Walgreen, for example, would have doubled in a year. But if you held until today, it would have returned more than 4,000%. The same goes for Kohl's. You could have sold for a quick double just a few months after the department store began trading in 1992, but you would have missed out on 2,500% total gains, and that's including the stock's 40% drop over the past year!

It's been more than four years, and our Hidden Gems cumulative returns thus far are gratifying. Our recommendations are up an average of 32%, while equal amounts invested in the S&P 500 over that time would have returned an average of 8%. 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 major winners from the past. Relatively few multidecade superstars are technology companies. And while we don't avoid tech stocks, they are a minority of our selections. We instead favor sleepy and underfollowed companies with high-quality management. The successes in our portfolio thus far include Chinese online travel agency Ctrip.com (Nasdaq: CTRP) and debt-collecting firm Portfolio Recovery Associates (Nasdaq: PRAA).

But for the ultimate example, think Wal-Mart.

In November 1980, Wal-Mart was trading at a split- and dividend-adjusted $0.16 per share. That's right, $0.16. 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 $0.16-per-share stocks. You won't.

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

With the stock trading around $53 as of this writing, it has returned 330 times in value over the past 27 years. A $5,000 investment back then is worth more than $1.6 million today. That'll clean up a lot of investment mistakes!

When Wal-Mart went public, it raised $4.5 million in cash to pay down debt. Wal-Mart was nothing back then. No one knew about it. Hardly anyone followed it, while dozens flocked to established giants such as Xerox (NYSE: XRX) -- a "safe bet" that has posted disappointing multidecade returns. And that plays right into our 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 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.
• On a related note, 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 more than $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; 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.

That's the aim of our Hidden Gems community every day, with thousands of members working together to examine the more than 7,000 public companies capitalized at less than $2 billion. We see the early outperformance in the long-term charts for IBM (NYSE: IBM), 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 to subscribe.

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

Tom Gardner is co-founder of The Motley Fool. He owns no companies mentioned in this article. Rex Moore is a Hidden Gems analyst, and he owns shares of Portfolio Recovery Associates and Ctrip.com, both of which are Hidden Gems recommendations. Wal-Mart is an Inside Value recommendation. The Motley Fool is investors writing for investors.