The Most Audacious Guarantee in Investing

In just a few minutes, I'm going to make an utterly bodacious, audacious, stupendous guarantee to you.

I'm so confident that I'm right, I'll change my legal name to Waldo if I'm wrong.

Years of research spanning nine decades, involving thousands of companies and millions of data points, back what I'm about to tell you. Seriously, you might as well accept it as being true. Because for one thing, I'll be damned if I'm actually going to go by the name "Waldo." (No offense to people named "Waldo," or to the people who love them.)

And for another thing, I hate being wrong.

So much outperformance, it's not even funny
There's a finance professor at Dartmouth College named Kenneth French (and there's no truth to the rumor that he was encouraged to change his name to "Kenneth Freedom"). Professor French collects market data and interprets it, looking for areas of the market that generate long-term risk-adjusted outperformance.

Among other things, he found that a single dollar invested in the small-cap value segment of the market in 1927 turned into more than $70,000 by 2005. That's a return of 15.4% per year. By the same token, the same dollar invested in the S&P 500 over the same time period turned into $1,700, a return of 10.0% per year.

You don't need me to tell you that that is a huge difference!

Even more unfunny outperformance
But another group, The Center for Research in Security Prices (CRSP), has another set of research that shows something amazing about small caps. From the period of 1946 through this past December, out of 709 rolling-three-year monthly return periods, in two-thirds of the periods, small-cap stocks returned better than 10% annualized. In three out of every 10 periods, small caps had annualized gains better than 20%.

All of this tells me that at Motley Fool Hidden Gems, the small-cap investing service I run, we're fishing in the right waters.

Certainly people get excited about companies such as overlooked industrial conglomerate Walter Industries (NYSE: WLT  ) , which has doubled since we recommended it little more than a year ago on the back of rising prices for metallurgical coal. But that much outperformance over that length of time doesn't depend on the relatively few companies with gigantic returns. Those are merely the ones that get the headlines.

Growth potential plus market inefficiency equal big returns
So while looking for a micro cap that has the potential to return your original investment several thousand times over as it becomes the next Wal-Mart (NYSE: WMT  ) is exciting, the real key to outperformance across small-cap companies is the fact that they are historically undercovered by Wall Street -- as Wal-Mart decidedly was in its early days as a public company.

Want to know why so few knew about voice recognition software company Nuance Communications (Nasdaq: NUAN  ) before we did? Because it didn't make much financial sense for a big investment bank to cover a sub-billion-dollar company.

Of course, when there's little in it for them, there's lots in it for you.

And now, that audacious guarantee
To me, the numbers above show why it makes so much sense to claw your way through the small, hidden sectors of the market. In fact, it makes so much sense, that here's my guarantee to you:

If you focus on small-cap investing, I guarantee that one morning you'll wake up with more than 20% of your portfolio evaporated.

Who could pass up an opportunity like that?
You see, the CRSP data, the same dataset that shows that small-cap stocks return 10% or more annually 65% of the time (over rolling-three-year periods), also shows that 3% of the time the same class of stocks have annual returns between negative 10% and negative 19.9%. So in any one of these rolling periods you'd go from having $1 to having between $0.73 on the high side to $0.51 on the low side. That, by the way, is three years later. Brutal.

In fact, getting back to our friend Ken Freedom (OK, perhaps I was the one that started the rumor), we find that in 2007, the value segment of the small-cap stock universe turned in a return of negative 15.2%. Some companies -- such as Charlotte Russe (Nasdaq: CHIC  ) and New York & Co. (NYSE: NWY  ) , which didn't look all that expensive to begin with -- lost 30% of their value or more last year.

Why would someone put up with heartache like that?
I'll tell you why. Look at French's data again. Small-cap companies dramatically outperform large-cap companies over the long term. And I know of no one whose long-term returns were enhanced by focusing on the short term.

Small caps beat large caps over the long term because they don't always beat it in the short term. In order for your dollar to grow into many thousands of dollars, you simply have to put up with -- and, even better, learn to exploit -- the times when the market goes south on you.

While finding a massive long-term winner such as Intuitive Surgical (Nasdaq: ISRG  ) can go a long way toward making your investment career successful, this stock has never traded for less than 28 times EBITDA. That makes it a growth stock, and Professor French's data shows that small-cap growth -- as a group -- underperforms the market over time. Because for every Intuitive Surgical, there's a company like TASER (Nasdaq: TASR  ) that struggles to get its product to market.

The better way to invest is to fish in the right waters, invest with high accuracy, and to keep 100% of your funds stashed in quality small-cap value companies.

The Foolish bottom line
At Hidden Gems, we focus solely on the small-cap sector, searching for value-priced businesses that promise to generate outsized returns over the next three to five years. Why three to five? Because it takes at least three years for superior companies to show their stripes.

To date, our picks are beating the market by 19 percentage points on average. Come join Hidden Gems free for 30 days to see the high-quality small caps we're recommending, and consider adding some of them to your portfolio.

You might find that you're not made to withstand the volatility, but if you can, I think the results will be pretty great. And that's another audacious guarantee.

Bill Mann once wrestled a bear. Hey, it was the last Ho-Ho, what would you have done? Walter Industries, Nuance Communications, and New York & Co. are Hidden Gems recommendations. Intuitive Surgical and Taser are Rule Breakers recommendations. Wal-Mart is an Inside Value recommendation. The Fool has an audaciously bodacious disclosure policy.


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  • Report this Comment On March 27, 2008, at 6:37 PM, steinbrock wrote:

    I agree with the article and just wish I had the knowledge to find the hidden gems myself. It takes time, patience and knowledge of research, which is why I'm following the "brains". I purchased Nuance awhile ago following your advice, and now just hope it turns into a STRONG hidden gem.

    Sillyjack

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