Wall Street's Worst-Kept Secret

Investors who make more money over the long term buy common stocks.

At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who want to make even more buy small-company stocks, also according to Ibbotson.

The way I see it, we have a few choices. We can roll the dice on a small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF) -- more on that later. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Sort of. You see, I recently had the pleasure of chatting with Motley Fool founder Tom Gardner -- an unusual investor who has made a good living buying well-run small companies ahead of Wall Street.

And you know what? I'm beginning to suspect that the team of analysts Tom assembled at Motley Fool Hidden Gems are on to something. I think they're building a portfolio of small companies I wouldn't have found on my own. What's the secret?

I think it's that Tom's guys focus on fundamentals, while I tend to get wowed by story. As it turns out, they religiously run prospects through a checklist of specific criteria when recommending small companies to their subscribers:

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

Good work if you can get it
Of course, who wouldn't want a portfolio filled with stocks like that? Good point. That's precisely the problem with trying to beat the pros with well-known, large-cap stocks -- if they're really all that, they're going to cost you.

So, what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not companies. This is a tricky distinction, so how about an example?

Google (Nasdaq: GOOG  ) , you'll recall, was a verb long before it was a stock. Yahoo!, meanwhile, hit Main Street and Wall Street at the same instant. Both were crawling with Wall Street analysts before you or I could get an edge.

But that's not always the case
What about teen retailers Abercrombie & Fitch (NYSE: ANF  ) and American Eagle Outfitters (NYSE: AEO  ) ? More than 20 analysts cover them now, but most investors heard about those companies from their kids long before their brokers ever brought them up. And those are just two examples.

There's always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Peter Lynch was a master at finding them. In fact, Wall Street outcasts like Gap (NYSE: GPS  ) and Taco Bell -- now part of Yum! Brands (NYSE: YUM  ) -- helped earn Lynch's Fidelity Magellan fundholders nearly 30% year after year.

We can do it, too
To prove it, my colleague Tim Hanson tracked down the best-performing stocks of the past 10 years. Check them out here. But don't expect to find story stocks and familiar names on the list. Instead, look for solid businesses that started as underfollowed stocks. For example, mid-tier biotech Celgene (Nasdaq: CELG  ) , which rode a few key drugs to more than 6,700% gains over 10 years.

They're not easy to find, but I hope you can see this is great news for investors like us. It proves we can find established, profitable companies with unknown stocks and ride them to big profits. Some you will have heard of; others you may not have -- yet. 

As for relying on the next Peter Lynch, a word of warning: Outperforming with a mutual fund is a crapshoot at best. That's why I like exchange-traded funds (ETFs) -- you get broad exposure to an entire group (like small caps) without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth (IJT) and Value (IJS) indexes.

What to do now
If you ask me, a strategy of holding these ETFs and scaling gradually into the stocks you hear about each month in Tom's Hidden Gems newsletter is a winner. After all, you want to be diversified, but sooner or later, you want exposure to a few great small businesses with massive potential.

Meanwhile, to prove I'm no fair-weather fan, I promise to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 32.5%, compared with 8.5% if you'd invested in the S&P 500 for the same period. That's a serious edge.

Even better, you can accept a free trial of the complete Hidden Gems service. That way, you can check out every current and past recommendation (including the team's top five picks for new money now), and read all the back issues online, for an entire month. Of course, there's no obligation to subscribe. To learn more, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. Gap and American Eagle are Stock Advisor picks. Gap is an Inside Value pick. You can view all of our Hidden Gems picks instantly with your free trial. The Motley Fool owns stock in American Eagle. The Motley Fool has a full disclosure policy.


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