Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



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.

Read/Post Comments (0) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 619577, ~/Articles/ArticleHandler.aspx, 5/31/2016 12:14:47 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 17,790.04 -83.18 -0.47%
S&P 500 2,094.81 -4.25 -0.20%
NASD 4,939.41 5.90 0.12%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

5/31/2016 11:59 AM
AEO $15.72 Up +0.07 +0.45%
American Eagle Out… CAPS Rating: ***
ANF $19.90 Down -0.29 -1.44%
Abercrombie & Fitc… CAPS Rating: *
CELG $107.09 Up +0.66 +0.62%
Celgene CAPS Rating: *****
GOOGL $748.51 Up +0.91 +0.12%
Alphabet (A shares… CAPS Rating: *****
GPS $17.93 Down -0.20 -1.10%
Gap CAPS Rating: ***
YUM $82.21 Down -0.38 -0.46%
Yum! Brands CAPS Rating: ****