Get Ready to Buy

"Over the years, small-cap stocks crush large and mid caps."

That's how I planned to open today. By now, I'd be making my case -- dropping names like Nagel and Quigley and Ibbotson.

And by ... now! my inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be shouting, or "What about survivorship bias?" And you'd be right. It's the one fatal flaw with using historical data: The future is not the past.

So forget the numbers
You don't need Excel to tell you that tomorrow's new industry leaders are small companies today. But you do need a few clues to find them before they're too expensive to buy. If history is any guide, we're looking for a smallish company ...

• Run by entrepreneurial zealots with big ownership stakes.
• Free of convoluted relationships with investment banks.
• Able to grow its sales and cash flow exponentially.

And there's one more thing: The stock hasn't hit Wall Street's radar yet, so we can benefit from pent-up demand for the stock when earnings and revenues pick up and the sell-side analysts finally catch on.

What do I mean, "zealots"?
How about David Filo and Jerry Yang? If you don't recognize their names, I bet you know their company: Yahoo! (Nasdaq: YHOO). And then there's Jeff Bezos. His work at Amazon.com (Nasdaq: AMZN) made him Time magazine's Person of the Year, for Pete's sake.

You don't need to check these guys' SEC filings to know they have huge stakes in their businesses. What's more, there's one born every day. That's the sweet spot in the stock market for investors like us. It lets us hitch our wagons to the next Jeff Bezos or Bill Gates.

Which is not to say that finding them is easy, but it can be done. We just need to be patient and pick our spots. Even better, we can take a cue from the Motley Fool Hidden Gems method and screen for companies with market caps of less than $2 billion that offer:

• Solid management with big stakes in the company
• Great, sustainable businesses
• Dominant positions in niche markets
• Sterling balance sheets
• Strong free cash flow.

Just remember those five keys
Again, they don't come along every day, but they do work. I was surprised to see that unassuming TJX (NYSE: TJX) is up some 30 times since 1990. Starbucks (Nasdaq: SBUX), a Motley Fool favorite since the mid-'90s, has earned investors more than 1,000%. Two in a million, you say? Maybe not.

Much the same happened with Rupert Murdoch's News Corp. (NYSE: NWS). And guess what? You don't have to be a media hound to get in on the action. If you're tech-minded, you could have followed security mastermind Denis Coleman into Symantec (Nasdaq: SYMC) and done just as well.

More recently, those five keys I just showed you led the Hidden Gems analysts to a double on online jewel retailer Blue Nile (Nasdaq: NILE). Although they later recommended a sell on that position, it's one of 20 Hidden Gems small caps that doubled or more in less than five years. (In the spirit of full disclosure, the team's picks are up an average of 32.7%, versus 9.1% for the S&P 500.)

This market got you on edge?
Honestly, I don't recall ever seeing volatility like this. It's easy to get defensive. But I still think this market's creating opportunities, if we're patient and selective. I've been buying on the dips. That's why I always have a wish list of great small companies on hand. You may need one, too.

If you're short on ideas, you can try out the complete Hidden Gems small-cap service free for 30 days. You won't be pressured to join, and you have a full month to decide whether it makes you a better investor and helps you make money.

Meanwhile, you can check out every one of the team's small-cap value recommendations since Day 1, including their five top picks for new money right now. The whole process takes about five minutes, and there's no obligation.

This article was originally published on May 10, 2005. It has been updated.

Paul Elliott does not own shares of any company mentioned in this article. You can see the entire Hidden Gemsscorecard with your free trial. Amazon and Starbucks are Motley Fool Stock Advisor recommendations, and the Fool owns some of Starbucks. Symantec is an Inside Value pick. Blue Nile is a current Rule Breakers recommendation. The Motley Fool has a disclosure policy.