If you own stocks, you should consider mixing in some small caps. Of course, that's not personal investment advice. It's Wall Street's worst-kept secret. Over the long haul, small-company stocks outperform mid- and large-caps.
You want an edge
Otherwise, you wouldn't still be reading. So why make this hard? Despite recent "evidence" to the contrary, investors who make the most money over the long term don’t buy bonds, or even gold.
They buy and hold common stocks. At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who want to make even more have dabbled in small caps, also according to Ibbotson.
Assuming that's true -- and that we still have the guts to buy -- we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). 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. Well, sort of. You see, I have the good fortune to down the occasional cup of joe with Tom Gardner. Tom, as you may already know, co-founded The Motley Fool back in 1993. He has also made a career out of beating the Wall Street pros to well-run small companies.
And I'm man enough to admit that the team of analysts Tom has assembled at Motley Fool Hidden Gems is building a portfolio of small caps I probably wouldn't have found on my own. What's their secret? I think it's that Tom's guys focus on value, while I have always loved a good story.
Yet for all our differences, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. A long line of smart investors have beaten the market by looking for:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
I know it's hard to imagine, but these traits gave investors the courage to follow Larry Ellison into Oracle (Nasdaq: ORCL) -- a one-time software start-up that later went on to battle AT&T (NYSE: T) and General Electric (NYSE: GE) for the top of the market-cap heap.
Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like Oracle? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those are now -- 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. There's a difference. Harley-Davidson (NYSE: HOG), for instance, had a cult following for years, but it was one of the great stealth stock stories of the past decade. Ditto for Coach (NYSE: COH) after being spun off from Sara Lee at the beginning of this decade.
Or compare Southwest Airlines (NYSE: LUV) with JetBlue (Nasdaq: JBLU). At one time or another, both satisfied most of Tom's Hidden Gems criteria. Yet JetBlue was a hot stock out of the gate. Southwest took years to register a blip on Wall Street's radar. Which would you rather own?
Here's one more idea
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet Apple is the only one of the 10 you'll ever hear about from your broker. And that's no coincidence -- though you might very easily recognize Green Mountain Coffee Roasters from "real life."
Put it altogether and you see our edge: We can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these companies, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% per year on average.
Some more personal advice
Test the waters with a low-cost fund like iShares S&P 600 Small-Cap Value Index (IJS) and then shift gradually into the stocks Tom’s guys tell you about each month in his Hidden Gems newsletter. Sooner or later, you want to be exposed to at least a few small businesses with big potential -- remember those names I mentioned earlier.
Even better, if you want to learn more about how Wall Street's worst-kept secret can help you beat the pros, think about this: Look into accepting a no-risk free trial of the complete Hidden Gems service. You can sneak a peek at all current and past recommendations, including the analyst team's top five picks for new money right now.
You can even print out every one of his back newsletter issues, if you like. Best of all, the first month is on me, and there's never any pressure 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. Apple and Coach are Stock Advisor recommendations. The Motley Fool has a full disclosure policy.
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