Wall Street's Worst-Kept Secret

Hey, buddy! Want some personal investment advice?

If you own stocks, you should own small caps. OK, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you money.

You're serious about this
You want an edge. So why make this difficult? History tells us that investors who make the most money over the long term buy and hold common stocks.

At least they have since Ibbotson Associates started keeping track back in 1926 (and yes, I think it's still true). Investors looking to goose their returns even more own small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy a small-cap exchange-traded fund (ETF) -- I own a few myself. 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 occasional cup of joe with Motley Fool co-Founder Tom Gardner -- a guy who made a career out of beating Wall Street to profits on small, well-run companies.

And you know what? I can admit that Tom and the team of analysts he hand-picked to manage his Motley Fool Hidden Gems newsletter service have assembled a portfolio of small caps I couldn't have found on my own. What's their secret? I think it’s that they focus more on value, while I tend to get wowed by story.

For all of that, we do look for many of the same things in a great small company:

  • Solid management with significant stakes.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

As hard as it is to imagine, these traits led investors to John Morgridge and Cisco Systems (Nasdaq: CSCO  ) back in the day; even Jeff Bezos and Amazon.com (Nasdaq: AMZN  ) . Granted, you had to be nimble to get to Amazon ahead of Wall Street, but I don't have to tell you how those investments worked out.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least in their prime? And you're right. That's why it's so hard to beat the pros with well-known stocks like those now; if they're really all that, they're going to cost you.

But what are you going to do instead? Take a chance on some fly by-night outfit? Good point. But notice I said well-known stocks -- not necessarily well-known companies. There's a subtle difference if you think about it.

To see what I mean, consider big retailers such as Target (NYSE: TGT  ) and Lowe's (NYSE: LOW  ) , for example. They're both heavily owned by institutional investors now, but that wasn't always the case. Both had strong regional and even national brick-and-mortar footprints long before they were closely followed on Wall Street.

Need more proof?
Check out Fool Tim Hanson's list of the best-performing stocks of the past 10 years. You won't find a bunch of "widely helds" like Dell (Nasdaq: DELL  ) or Microsoft (Nasdaq: MSFT  ) on the list. Though don't be surprised if you recognize a company like drink-maker Hansen Natural from "real life" -- just as you probably recognized Target and Lowe’s from the strip mall. 

Of course, that's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these undiscovered gems. That's how he earned his Fidelity Magellan fundholders nearly 30% year after year.

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 that Tom Gardner'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 to the complete Hidden Gems service. You can sneak a peek as the team invests in a real money portfolio.

You can even print out every back issue, if you like. Best of all, the first month is on me, and there's never any pressure to subscribe. I haven't seen a market better suited to small caps since 2003. I bought then, and I'm buying now. To learn more about trying Hidden Gems for free, simply click here.

Already subscribe to Hidden Gems? Log in here.

This article was originally published Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P Small-Cap 600 Growth Index and the iShares S&P Small-Cap 600 Value Index. Amazon.com is a Motley Fool Stock Advisor pick. Dell and Microsoft are Inside Value choices. Hansen Natural is a Rule Breakers selection. You can see the entire Hidden Gems scorecard with your free trial. The Motley Fool has a full disclosure policy.


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