The Next Stocks You Should Buy

"Buy a small-cap stock."

I just wrote myself this simple note. See, lately I've been on a streak of buying large-cap stocks.

I'm likely not alone
The lion's share of mutual fund assets are tied up in large companies (in the list of the largest U.S. mutual funds, there's not a single small-cap-focused fund in the bunch). What's more, the S&P 500-tracking SPDRs exchange-traded fund took in $4.5 billion in the past 30 days -- by far the biggest inflow of any ETF.

And while institutions account for a fair chunk of that inflow, the overall numbers are more startling. All told, SPDRs has more than $70 billion in assets; its small-cap cousin, the iShares Russell 2000 Index, has less than $8 billion.

On asset classes and tautologies
Large-cap companies are widely followed, popular, and extremely newsworthy. And while it might seem obvious, they are also widely owned.

The big money follows the big stocks. I'm certainly not big money, but you can call my recent large-cap buying frenzy a flight to "safety" in a shaky market or you can chalk it up to buying undervalued stocks (I prefer to think the latter).

Either way, the fact remains: Investors probably have enough large-cap exposure already. With so many dollars tied up in large-cap mutual funds or S&P trackers like the SPDRs, we already have significant stakes in big names like blue-chip big boys Apple (Nasdaq: AAPL  ) , General Electric (NYSE: GE  ) , and Cisco (Nasdaq: CSCO  ) .

Which is why I reminded myself to buy a small-cap stock.

Look, I'm a firm believer that large caps should be at the foundation of every equity portfolio, but if you're like me and have a long-term time horizon (15-plus years) and capital appreciation is your primary investment objective, you need small-cap stocks. There are no two ways about it.

Do it. DO it.
For starters, unless you've made a concentrated effort to gain small-cap exposure in your portfolio, you may well be underallocated to this asset class. And that's a mistake: Small-cap stocks give investors the best chance at outperforming the market over the long haul. NYU professor Aswath Damodaran found that from 1927 to 2001, the smallest companies outperformed the largest ones with a 20% annual return versus 12% on a value-weighted basis. Many of the most successful small caps were:

  • Underfollowed by Wall Street.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

These were traits shared by the likes of Wal-Mart (NYSE: WMT  ) and Starbucks (Nasdaq: SBUX  ) early on, and they turned out to be some of the best stocks of our generation. Thirty years from now, it's very possible we'll look back at some of today's small caps and wonder how we missed those massive opportunities.

Great companies are out there
Back in March 2007, I wrote about Sun Hydraulics, at the time a $250 million purveyor of screw-in hydraulic cartridge valves and manifolds for things like bulldozers (yawn!) that I thought shared similar traits to those three great aforementioned companies.

Fast-forward 16 months, and Sun Hydraulics shares have risen 140%. Such a quick validation of an investment thesis doesn't always happen, but it's sure nice when it does.

I'm happy with Sun's performance -- I still own shares -- but owning one or two small caps does not a diversified portfolio make.

Making it happen
There are various ways to add small-cap exposure, among them ETFs and mutual funds. Both are perfectly valid options, but they have their drawbacks. For one, the more popular funds like Vanguard Explorer (VEXPX) have so much money under management that they must spread out their bets over 1,000 or more stocks (1,231 in Explorer's case) lest they take an ownership stake in the company or drive up the share price. That's problematic for investors because it waters down the growth potential of small caps. Sure, Cephalon (Nasdaq: CEPH  ) may be a great stock, but since it makes up only 0.8% of Explorer's portfolio, any outperformance won't make a huge difference to the fund.

An alternative is to handpick your own small caps. I know what you're thinking: "Aren't small caps risky?" Just as with any stock, yes they can be. For my money, though, I'd much rather back a small company with a strong management team and a rock-solid balance sheet than a "safer" large company with newly appointed management and hard-to-understand financial statements.

Convinced yet?
Not only are small caps the best long-term performers, they're also the best stocks to come out of bear markets. So if your portfolio could use a bit more growth potential, the next stocks you buy should be:

  • Small.
  • Underfollowed.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

These are precisely the types of companies our Motley Fool Hidden Gems team looks for, and over the past five years their picks have outperformed the S&P 500 by more than 19 percentage points on average. If you'd like to learn more about how small caps can help fuel your portfolio's growth, a free 30-day trial to Hidden Gems is yours by clicking here.

Todd Wenning hopes you're enjoying your summer. He owns shares of Sun Hydraulics, but of no other company mentioned. Sun Hydraulics is a Motley Fool Hidden Gems pick. Wal-Mart and Starbucks are Motley Fool Inside Value selections. Apple and Starbucks are Motley Fool Stock Advisor picks. Vanguard Explorer is a Champion Funds pick. The Fool owns shares of Starbucks and SPDRs. The Fool's disclosure policy is brought to you by the No. 3.


Read/Post Comments (29) | Recommend This Article (102)

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.

  • Report this Comment On August 01, 2008, at 4:50 PM, DenimAdept wrote:

    If something is all good but underfollowed to the extent of being completely overlooked, how do we find out about it?

    I stopped buying your newsletters because they cause price bumps all by themselves, so I want something you guys haven't noticed.

  • Report this Comment On August 01, 2008, at 11:22 PM, erad1 wrote:

    re denim adept's comment. i used to really enjoy motley fool but nowadays i find it is all just one big sell for some market newsletter or other.

  • Report this Comment On August 04, 2008, at 11:33 AM, boxing wrote:

    what about loop

  • Report this Comment On August 06, 2008, at 1:14 PM, DenimAdept wrote:

    Correction: I want to find something you guys haven't noticed YET. You're welcome to notice it after I've got some. :-)

  • Report this Comment On August 08, 2008, at 10:25 AM, mako102 wrote:

    I'm tired of these teasers as well. There's a header like "the next 5 stocks you should buy" and I get a long sales pitch. The answer should be in the text for current subscription holders and save the teasers for non-members.

  • Report this Comment On August 08, 2008, at 1:12 PM, natjoy wrote:

    Mako102 and DenimAdept are right...sorry Todd Wenning. Also - from a consumer relations perspective, you might want to employ a softer touch. There are MANY places that we can get our investor information - as a content provider who benefits from our subscriptions as well as from the ad revenue our page turns generate - you should listen to your audience...rather than dismiss their opinions with a "do or don't decide to try it out." Companies pay enormous amounts of money to get the honest feedback that you've received in this message board - and it IS accurate. Motley Fool is gaining a reputation for shilling subscriptions and fulfilling it's own agenda, rather than providing insight. It's why I ended my paid subscription about a year ago. I came back today, having again been "fooled" by the headline - adding more validity to your increasingly earned reputation. If this is the first time you're hearing about it, I'd be highly amazed.

  • Report this Comment On August 08, 2008, at 1:15 PM, SylviaBlum wrote:

    Hidden Gems was the MOST nerve-wracking newsletter I ever got (and I've had many). The minute a buy was suggested it was all over Yahoo, and other sites with thousands of people triggering instant buys...moving the stock up by leaps and bounds before I even had a chance to read why you were suggesting it. I don't know how many members you had in HG but the word of your buys got out to the general public far to fast. And, to make matters worse, you got in at a great price, taking credit for being genius' and the rest of us were left in your dust.

  • Report this Comment On August 08, 2008, at 1:55 PM, OldGuard15 wrote:

    I am seriously considering dropping my account with you. All I seem to get is the same old thing. The ads are rediculous as you struggle to get to the meat of the subject. That is compounded by constant repition of how one or two stocks made like Marvel or Walmart shareholders millions of dollars if you bought when you first offered stock. I am also upset that the Fools keep repeating a stock or two that they picked and how it had outstanding results.

    I need a concise abstract of what to do now, not 20 years ago. So far, the two stocks I bought on your recommendation have gone down dramatically. If I do not see an improvement in your performance, I will have to look elsewhere for advice. It is your last chance with me..

  • Report this Comment On August 08, 2008, at 2:08 PM, rosen2 wrote:

    I can't agree more with those who wrote that most of the material they get is a teaser - the latest is "five stocks you can't do without" - but not even one is mentioned. Shame on you!

    rosen

  • Report this Comment On August 08, 2008, at 2:38 PM, rllaugh54 wrote:

    I have to agree to the above comments. All I get in my e-mail is come ons and no real advice.

  • Report this Comment On August 08, 2008, at 3:54 PM, jaykar16 wrote:

    Wow,

    I hope Bill and Tom are reading this and do something about it. At least make a statement concerning the above comments. As for me who was just about to take some fools advice and buy on some of the recommendations, I think I'll wait. Also, I agree with the statements and I am now not sure if I will re-subscribe. Give us the information and save the sales talk for your competition. We have just enough time to read whats necessary before we have to work 10 hours 5 days per week, complete the honey-do list, take care of the kids, take care of Mom and list goes on. Thank you.

  • Report this Comment On August 08, 2008, at 4:17 PM, theFischers wrote:

    Count another vote for a detailed review of policies and feedback regarding spamming subscribers. While I know I can "turn off" certain MF emails, I fear (as most do) that I'd miss something relevant if I did.

    I started with a HG subscription and dropped it as well. I never seemed to get information that was "actionable" in any timely way. It felt like I was reading old news.

    Please please please...if you're going to send newsletter invitations under the pretext of "The Best of the Week", make it timely and actionable with specific recommendations.

  • Report this Comment On August 08, 2008, at 4:17 PM, dlcapo wrote:

    I'm a current HG's member (4 yrs.)but Motley Fool now has so many Services it makes me wonder if I'm getting the best recomendations they can give me. Here today I see yet another new subscription service being offered to "HG members" ( for more $ of coarse) Didn't bother to read it as I've bitten on that hook too many time before.

    How many stocks that might qualify as a Hidden Gem are released thru a different subscription title, Global Gains, Income Investor or maybe Inside Value ?

    It's starting to look like a crap shoot. Hope you get your chip on the right #.

    This may be my last year for renewal. It's getting a little watered down for my Buck. I'm paying for one and feel I'm missing something somewhere else.

    dlcapo

  • Report this Comment On August 08, 2008, at 5:48 PM, marwegee wrote:

    I am relatively new to Motley, and I have to tell you I totally agree with what these posters are complaining about. You put out a lot of bait but there is nothing on the hook. This is looking more and more like a pro mo for a lot of other newsletters and it takes a lot of reading to get nothing. If this continues I do not see the need to subscribe again.

  • Report this Comment On August 08, 2008, at 7:04 PM, momthrone wrote:

    I wholeheartedly agree and did not renew my subscription to Hidden Gems. That's a shame, because I like the premise of the Motley Fool and I also hoped it would be a valuable resource to pick some great small caps. I have been disappointed and also feel that in some ways I'm being spammed by a company I've given money to.

  • Report this Comment On August 08, 2008, at 7:40 PM, hope2learn wrote:

    Wake up Motley Fool.

    I received your teasers for years now (at least 4 years). I've been on at least 3 different subscriptions at different times, just kept baited (and biting) some more.

    I've finally knocked off all subscriptions about six months ago, and when I check today - same old, same old - feels more like fraud than spam.

    Btw, all of the recommendations -- my net result so far -- I'm 30% down and counting!

    Thanks for nothing.

  • Report this Comment On August 08, 2008, at 7:54 PM, xtrump42 wrote:

    Much of what the posters above have said is all too true. The weekly newsletter is next to useless. But where I find TMF useful is the watchlist I maintain on yahoo finance. Comments by TMF contributors (among others) about the stocks on my list are often very informative and worth heeding. For example a news item about Jones Soda today was highlighted on YF because it mentioned PNRA, which I own. My point? The comment about Jones was very negative, warning me to not consider it.

    As for subscribing to any of TMF paid subscription letters.... I've tried a couple. They didn't help much. As a Canadian there is distinct tax advantages in investing in Canadian companies vs US or int'l so 80% of my portfolio is with the Toronto exchange. No Motley Fool news letter ever even mentions the TSX.

  • Report this Comment On August 09, 2008, at 11:02 AM, bulldogjr wrote:

    I too am tired of the "teaser" headlines everyday in my email box. I already subscribe to "Hidden Gems" and I am too busy to open emails telling me about stuff I alreadly have available. How about a once a month message to Hidden Gems subscirbers and save us from all of the marketing b.s. Thanks,

    Bulldog

  • Report this Comment On August 09, 2008, at 12:21 PM, dollarfor40cents wrote:

    While the constant sales pitch can get annoying, I appreciate the exposure to ideas and education MF has given me.

    In the end MF is a business just like the ones they are covering, so sales and marketing is a logical arm of that business. To tell them to stop advertising as much is to tell them to limit growth, something we'd rarely want our investments to do.

  • Report this Comment On August 09, 2008, at 1:31 PM, gmogros wrote:

    I keep reading these negative comments for some time and wholeheartedly agree. Apparently no one at TMF listens to these complaints since too often you find another one in your email. I consider my subscription to TMF my greatest investment mistake since I got absolutley nothing for what I paid. To make it worse, each email reminds me of the mistake I made. I seriously consider putting TMF on my SPAM list and forget about the money I paid for nothing.

  • Report this Comment On August 09, 2008, at 2:13 PM, Al0012 wrote:

    I also have serious doubts about usefulness of this highly pitched newsletters. In general, it is a good read, but specific picks are just a bunch of stocks that already grown 300%. That does not mean the stocks are bad, it's just somebody picked all cream before us.....

    I still think that a serious investor/trader can pick his/her own stocks after thorough research and watching his list for a while. Also important to set your own rules about entry,exit, size of individual position etc Fundamentals are good for long term, charts are good for timing.

  • Report this Comment On August 09, 2008, at 8:28 PM, skleiniv wrote:

    I bought in and swallowed the hook for the MDP only to find out after spending all that money that it doesn't allow me access to all your newsletters. How can you offer a MDP and not give your readers access to everything? give us something we can use instead of all these promo's to spend more and more $ for an endless # of newsletters. it's frustrating that I lost more money on the SFNS (Stupid Fool Newsletter Scam) than I have in the markets!

  • Report this Comment On August 09, 2008, at 9:03 PM, rander6853 wrote:

    Have to agree with all the other notes here. I did not sign up and pay a fee to get the same martketing hype that I can get for free. I really thought that the service would be more specific on reccomendations. Very disappointed.

  • Report this Comment On August 10, 2008, at 11:47 AM, skoobagain wrote:

    I agree with parts and pieces of all of the above but mostly w/mrdatman. Presumably we are all intelligent enough to sort out a 'come-on'/sales pitch when we see/hear one. But I use these sales pitch emails as reminders to go to my Motley Fool Watchlist. I check in and run by the other members any companies I have read about or noticed in the course of a day or week. I love the info. and the other homework is up to me. skoobagain

  • Report this Comment On August 10, 2008, at 1:49 PM, Johnwzee wrote:

    I too am tired of your constant sales pitches. More real substance and less teasers. I dropped another "reference" sevice because their teasers became too much to put up with. Fools are fast approaching that status.

  • Report this Comment On August 10, 2008, at 3:01 PM, bcave34481 wrote:

    I HADN'T REALIZED THAT SO MANY MEMBERS FELT LIKE I DO.

    WHEN I GOT SOLD DOWN THE RIVER WITH AFR I SHOULD HAVE LEARNED MY LESSON.

  • Report this Comment On August 10, 2008, at 11:33 PM, 2zippie wrote:

    I agree with all the above regarding teasers placed in EVERY issue. When I subscribed to the Motley Fool I thought I would be privy to all the investing info their service had to offer not just a small percentage of it. Since joining I have been bombarded with sales pitches, trial offers for additional info that costs more $$$. I too have grown weary of reading through info that serves no purpose but to be used as a filler. Now that I am use to the format It seems to read like blah,blah, blah. It seems to you have to read through a lot of the blahs before you get to the info you were led to believe is there only to find its not. I am also tired of reading the SAME article about marvel, walmart & what you would have if you would have purchased 30years ago. Most subscribers are interested in what to to now not could have, would have,should have. None of the info I have received from MF I have found useful.

  • Report this Comment On August 11, 2008, at 11:46 AM, davro wrote:

    I've been a subscriber of Stock Advisor since it started. Most of the stocks I've bought went up quite nicely. Some that I got scared out of, went up with out me. Its all about the time frame and patience.

    I'm within 5 years of retirement so I'm trying to be very careful about risky investments. Most of the newsletter here seem to be geared toward long term investments or income producing for someone already retired. I would like to see one geared toward low risk growth with "some" exposure to small or mid cap but primarily income preservation.

  • Report this Comment On August 12, 2008, at 10:40 AM, spastic100 wrote:

    Motley Fool is becoming the Wal-Mart of tabloid investing. The stuff maybe cheap but it has become mostly junk.

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