Pop quiz, hot shot. Name the company that's most likely to be a 10-bagger by 2020.
It's a hard question. There isn't just one correct answer -- you can find three candidates here -- but it's easy to weed out some popular incorrect answers.
If you named Cisco (Nasdaq: CSCO ) , Johnson & Johnson (NYSE: JNJ ) , Kentaco Fried Hut parent Yum! Brands (NYSE: YUM ) , or any other large-cap company, you're probably wrong. They're simply too big to grow tenfold in the next decade. My Foolish colleague Tim Hanson has shown year in and year out that a decade's biggest winners are small-cap stocks.
He found that the largest grower of the last 10 years, beverage company Hansen Natural, was almost a 50-bagger. Even at 50 times its original market capitalization, Hansen is a $3 billion company -- one-fifth the size of Yum Brands, a fortieth the size of Cisco, and a fiftieth the size of Johnson & Johnson.
It gets better
Besides having room to grow, small caps have another hidden feature. They are more volatile than their large-cap brethren. This can lead to fluctuations that are absolutely heartbreaking for investors with low risk tolerances. But for those of us with higher risk tolerance, the volatility provides opportunity.
As we've seen recently, large-cap stocks can be quite volatile, too. When their price losses significantly outstrip the market's, though, there's usually something terribly amiss.
Familiar examples abound. Take the gambling industry and former large caps MGM Grand (NYSE: MGM ) , Las Vegas Sands (NYSE: LVS ) , and Wynn (Nasdaq: WYNN ) . If they recover, each could be a multibagger from here. However, they're all priced at fractions of their former highs because their balance sheets weren’t built for a gambling environment crippled by a faltering economy.
Meanwhile, small caps are a little different. Sometimes, as in the case with Boyd Gaming (NYSE: BYD ) , small caps are down for a reason. But, since they tend to have greater volatility than the market as a whole, sometimes they experience dramatic stock price tumbles on very little news. Or even on relatively good news.
A quick example
Take the recent case of restaurant company Buffalo Wild Wings. Back in late October, it reported quarterly earnings that were disappointing. But given the state of the economy in general and the restaurant sector specifically, the results were downright robust: positive earnings-per-share growth and impressive same-store sales growth (6.8% at company-owned stores).
In response, shares were sliced in half in the month following the earnings release ... only to gain it all back and then some after the company beat analyst expectations in the subsequent quarter. Over the past few months, it's been the same company with the same long-term prospects. There have been no huge company-related events, and its price is about the same now as it was a year ago.
But somewhere in the middle, the market threw a half-off sale for investors patient enough to wait for a discounted entry point. Since they took advantage of volatility, those investors need only a five-bagger from here to reach the vaunted 10-bagger status.
The 10-bagger club
In 2020, when we look back at the decade's list of 10-baggers, the list will be dominated by stocks that can be described as:
The list of investors who profit from these 10-baggers will be dominated by people who can be described as:
If you have these two qualities, I invite you to join our analysts at the Motley Fool Hidden Gems newsletter. They are putting the Fool's money where its mouth is by building a real-money portfolio of small-cap stocks. You can see all the companies they're investing in with a free 30-day trial. If you're not impressed, there's no obligation to subscribe.
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This article was originally published on May 15, 2009. It has been updated.
Anand Chokkavelu does not own shares in any company mentioned. Johnson & Johnson is a Motley Fool Income Investor pick. Hansen Naturals is a Rule Breakers choice. Buffalo Wild Wings is a Hidden Gems recommendation. The Motley Fool owns shares of Buffalo Wild Wings and has a disclosure policy.