Wall Street's Worst-Kept Secret

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Hey, buddy, you want some personal investment advice? Investors who make the most money over the long term invest in common stocks – no matter what the doom-and-gloomers tell you.

At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who make even more invest in small-company stocks, also according to Ibbotson. But that’s not personal investment advice -- that’s Wall Street’s worst-kept secret.

The way I see it, there are few ways we can play it right now. We can roll the dice on a small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF) – I’ve owned a few myself for years. 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. I recently had the pleasure of discussing the subject with Motley Fool co-founder Tom Gardner -- a guy who's made a career out of digging up well-run small companies ahead of Wall Street.

I'm beginning to suspect that Tom is onto something, and that the team of analysts he assembled to run his Motley Fool Hidden Gems newsletter service has built a solid portfolio of small companies I couldn't have found on my own – including more than a dozen that have doubled at least.

What's their secret? I think it’s that, when searching out well-run small companies, these guys focus on fundamentals, while I tend to get wowed by story. More specifically, they insist on a few important criteria when searching for great small companies:

• 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 now, but many of these same traits gave investors the courage to follow a young Howard Schultz into Starbucks (Nasdaq: SBUX), a longtime Motley Fool favorite. The same goes for Sam Walton and Wal-Mart back in the 1970s. Both were pretty decent investments for years.

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

But 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 necessarily well-known companies. There's a difference.

For example, flashy tech outfits with sexy names like Level 3 Communications (Nasdaq: LVLT) and Tellabs (Nasdaq: TLAB) are often familiar tickers long before many traders figure out what they actually do. Companies like BJ Wholesale Club (NYSE: BJ), on the other hand, have strong regional or even national footprints long before they hit Wall Street's radar.

Need more proof?
Check out my buddy Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of story stocks like Sirius XM Radio (Nasdaq: SIRI) or Suntech Power (NYSE: STP). In fact, I'm willing to bet you haven't heard of more than one from your broker, though you might recognize a bunch from "real life" -- Green Mountain Coffee Roasters (Nasdaq: GMCR), for example.

And 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 gems. That's precisely how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, beating the market with a mutual fund is a crapshoot. That's why I'm a fan of exchange-traded funds (ETFs) -- you get broad exposure to the entire group without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth Index (IJT) and the value index.

Some more personal advice
Consider testing 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.

Even better, if you’re curious 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. That way, you can look on for free as the team builds a real money portfolio of small-cap stocks.

You can even print out every back issue and check out all the recommendations, 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.

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. Starbucks is a Motley Fool Stock Advisor pick. Wal-Mart and Starbucks are Inside Value picks. Suntech Power and Green Mountain Coffee Roasters are Rule Breakers choices. The Fool owns shares of Starbucks and has a full disclosure policy.