No matter how bad this market gets -- and no matter how much it tests your faith -- remember this: U.S. investors who make the most money over the long term buy and hold common stocks.
At least, they have since Ibbotson Associates started keeping tabs way back in 1926. Investors who want to make even more hold small-company stocks in their portfolios, also according to Ibbotson.
The way I see it, we can skin this cat one of three ways. 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 chatted with Motley Fool co-founder Tom Gardner -- a successful investor who has made a good reputation searching for well-run small companies ahead of the Wall Street crowd.
And you know what? I'm beginning to think that Tom and the analysts he recruited to manage his Motley Fool Hidden Gems small-cap investment advisory service day to day are on to something. Frankly, they are building a portfolio of small companies I wouldn't have found on my own.
What's the secret? I think it's that these guys focus on fundamentals, while I tend to sucked in by story. And they're thorough. Before they pass a recommendation to their subscribers like me, they run dozens of prospects through a checklist, looking for:
- 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? 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 and risk your money on some fly by-night outfit? Point taken. But notice I said well-known stocks -- not companies. This is a tricky distinction best illustrated with a few examples.
Google (Nasdaq: GOOG ) , you'll recall, was a verb long before it was a stock. Yahoo! (Nasdaq: YHOO ) , meanwhile, hit Main Street and Wall Street at almost the same instant. Yet in each case, the stocks were crawling with Wall Street analysts before you or I could ever hope to get an edge. In other words, they were story stocks.
But that's not always the case
What about teen retailers PacSun (Nasdaq: PSUN ) and American Eagle Outfitters (NYSE: AEO ) ? Dozens of analysts cover them now, but most investors heard about those companies from their kids long before their brokers. And those are just two examples of companies that started out as small, proven businesses with solid fundamentals that for a while flew below Wall Street's radar.
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, it was Wall Street outcasts like Gap (NYSE: GPS ) and Taco Bell -- now part of Yum! Brands (NYSE: YUM ) -- that helped earn Lynch's Fidelity Magellan fund holders 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, there's mid-tier biotech Celgene (Nasdaq: CELG ) , which rode a few key drugs to 4,214% gains over 10 years.
Don't get me wrong; these companies aren't easy to find. But I hope you can see how this is great news for investors like us -- especially after all we've been through this year. These examples prove that 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. 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 managed funds. Both the iShares S&P SmallCap 600 Growth (IJT) and Value (IJS) indexes are solid choices.
Here's a better idea
If you ask me, a strategy of starting with these ETFs and scaling gradually into the stocks you can hear about each month in the Motley Fool Hidden Gems newsletter is a winner. After all, you want to be diversified, but sooner or later, you'll want a little more exposure to a few great small businesses with massive potential.
And I truly believe that now is the time to start looking. If you're ready, but need a little encouragement and some good stock ideas, accept a free trial of the complete Hidden Gems service. You can check out every current and past recommendation (including the team's top five picks for new money now).
You can even read all the newsletter issues online and print them out if you like. Your first month is on me, and there's no pressure to subscribe. That's how convinced I am it's time to start shopping. To learn more and have a look, 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. Google is a Rule Breakers recommendation. You can view all Hidden Gems picks instantly with your free trial. The Motley Fool has a full disclosure policy.