The Case Against Small Caps

Ever hear the one about the handyman who hung up his hammer at 35 after betting the farm on Home Depot (NYSE: HD  )  back in 1985? Warms your heart, right?

But we live in the real world. What about the less-fortunate chumps who get wiped out when their hot stock tip suddenly goes belly-up? Isn't that the "problem" with taking a flier on small, less-known stocks, after all? That they're a crapshoot?

You're smart to think that way
Go to Harvard Business School, and they'll tell you the same thing. Just be sure to pack a few hundred grand in small bills. Or save yourself some cash and consider something else. What if the problem isn't with small-cap stocks per se, but small-cap investors?

Seriously. Maybe they just attract the wrong crowd. Maybe all those gamblers and daredevils, swinging for the next home run, simply create the "illusion" of a wacky and treacherous market.

Don't take my word for it -- a good bit of data supports that contention. See Ibbotson, for starters. But here's a question that transcends any piece of disputed data: Can we use this "illusion" to make money?

Why small-cap investors get creamed
Any finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are lumpy and less reliable. Capital is costly and hard to come by, especially when times get tough.

All true, but I'm not convinced that's why so many small-cap investors lose their shirts. I think it's because they don't invest. Instead, they speculate on stock tips and high-risk story stocks with low-quality -- or worse, no -- real earnings. It's that simple.

Small-cap investors -- too many, at least -- ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small company at a party or on TV, and he wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who fuss over mature, large-cap, cigar-butt-and-smokestack companies trading at bargain-bin prices. Could these guys be more boring? They never talk story or potential. They're all hidden assets, cash flows, and valuation.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. Can you make money on fallen angels like Ford (NYSE: F  ) or Sprint Nextel (NYSE: S  ) ? Sure. The same goes with big financials like Citigroup (NYSE: C  ) and AIG (NYSE: AIG  ) .

But their triples and quadruples are mostly behind them. They're still too big. Now, what if we took the old-school valuation techniques made famous by Ben Graham and Warren Buffett and applied them to up-and-coming smaller companies whose growth spurts are still ahead of them? Again, I know it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget "the next home run stock"
If you're a regular here, you know I'm a fan of Motley Fool co-founder Tom Gardner. Along with people like Chuck Royce and David Nierenberg, Tom's team over at Motley Fool Hidden Gems are among the few I've seen cash in on this little "trick."

The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals selling at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing the fun stuff -- "story" and "potential" -- with old-fashioned fundamentals and valuation.

Tom Gardner likes to point out that this is what led investors to Wal-Mart in the '70s. And that they turned a $5,000 investment into $2.5 million. But what was so great about Sam Walton's general store back in 1975? A few things.

Follow the money
For starters, Wal-Mart was rapidly expanding its revenues and profits, even back in 1975. That's clearly not the case with too many of today's hot story stocks. Which isn't to say they don't have potential. Unfortunately, they're all "potential."

Investors were blindsided by a 15% drop this morning when tiny chip maker SMART Modular (Nasdaq: SMOD  ) reeled in its third-quarter outlook. Shares of reeling Pacific Ethanol (Nasdaq: PEIX  ) , meanwhile, have gone absolutely bonkers the past two days, after the company announced better-than-expected first-quarter earnings.

Clearly, speculating on companies like these may work out for you, but it's a rough ride. But that's not to say we should never take a flier. But the safer play is to dig up companies like Wal-Mart -- when they're still small but making money -- that can make you money methodically over the years.

After all, this "trick" turned $1,000 into $33 million
Granted, it took nearly 70 years to do it, but according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large caps instead. Will those numbers hold up? Well, the guys at Hidden Gems have been at it for a couple of years now -- judge for yourself.

So far, they have recommended dozens of small-cap value stocks. More than a dozen subsequently doubled or more, and as of this morning, the entire portfolio is up 38.3% on average per pick. That's considerably more than double the 13.7% return of the S&P 500.

How about some really good news?
You don't have to pay Harvard to find great small-cap values any more. You can pick up Ben Graham's Security Analysis, if you're up for flipping through 700 pages, that is. But there may be an even easier way -- with no heavy reading or speculation required.

You can check out Hidden Gems free for 30 days. This way, you can sample the complete service for a full month, including all recommendations and every newsletter issue and special report ever published. Then take a whole month to decide whether you want to sign up.

Meanwhile, you'll be joining forces with a community of smart and friendly investors, and nobody will pressure you to subscribe. Best of all, the first lesson ... and the team's top five small-cap value picks for new money right now ... is on me. Talk about low risk. To take advantage of this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on the progress at Hidden Gems (yes, through good times and bad). You can view all picks immediately on the Hidden Gems scorecard with your free trial. Paul doesn't own any stocks mentioned. Home Depot, Wal-Mart, and Sprint Nextel are Motley Fool Inside Value recommendations. The Motley Fool has a disclosure policy.


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