Wall Street's Worst-Kept Secret

Hey, buddy, do you want some personal investment advice? Investors who make the most money over the long term invest in common stocks -- no matter what the perma-bears 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 this long-term trend 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. You see, I recently had the pleasure of discussing the subject with Motley Fool co-founder Tom Gardner, 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 are building a portfolio of small companies I wouldn't have found on my own – including 19 that have at least doubled.

What's their secret? I think it's that Tom and his team 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, believe it or not, for Wal-Mart's Sam Walton, when Wall Street investment banks were laughing him out of their offices 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 it's hard to beat the pros with well-known stocks -- not necessarily well-known companies. There's a difference.

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

Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of story-stock broker favorites 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 of Hanson's stocks from your broker, though you'll recognize a number of them 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 will have heard of; some you may not have. Peter Lynch was a master at digging up these jewels. That's a big part of how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, finding the next Magellan is a crapshoot at best. 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 its sister value index.

A strategy to consider
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 analysts dig up for you each month in his Hidden Gems newsletter. After all, you can do fine with ETFs, but sooner or later, you want to be exposed to at least a few small businesses with big potential.

If you're curious how Wall Street's worst-kept secret can help you beat the pros, look into accepting a no-risk free trial to the complete Hidden Gems service. You can follow along for free as the team builds a real-money portfolio of small-cap stocks.

Heck, you can even print out every back issue and check out all the recommendations. Best of all, the first month is on me, and there's never any pressure to subscribe. Look, we've had a nice run, but I haven't seen a market better-suited to small caps since 2003. I bought then, and I'm buying now. If you want to join me, or to learn more about trying Hidden Gems for free, simply click here.

This article was originally published 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 is an Inside Value pick. Suntech Power and Green Mountain Coffee Roasters are Rule Breakers choices. The Fool owns shares of Starbucks and has a full disclosure policy.


Read/Post Comments (10) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 11, 2009, at 8:02 AM, misther153 wrote:

    So, what does Level 3 do?

  • Report this Comment On November 11, 2009, at 8:03 AM, misther153 wrote:

    So, what do Level 3 and Tellabs do?

  • Report this Comment On November 11, 2009, at 9:13 AM, stocknblondes wrote:

    The 10 negative press releases by the street . com against siri xm seems to have left even the fools speechless yesterday, wow that's first, Maybe you guys could write a little article for us retail investors on why the street . com would go to so much trouble to pick on a little ole' Pennie stock that they deem "worthless"..C'mon fools give us some insight, you listening Rick? once again 10 different negative articles yesterday wow.

  • Report this Comment On November 11, 2009, at 9:29 AM, cantbefoolish wrote:

    All of those negative posts yesterday just reiterates how much in competition they are with Sirius/XM. They want SIRI to fail. So they will drown out the positive news, with tons of negative attacks. It shows how scared they really are. But the ones who will fail are TSCM and MF. Never bet against Howard and Mel.

  • Report this Comment On November 11, 2009, at 11:25 AM, dishguy1967 wrote:

    The sec should shut down the fool and the street...or make them merge and call them streetfools...anyway who cares they are just a bunch of flunkies try to pick stocks and failing.

  • Report this Comment On November 11, 2009, at 12:19 PM, Macpherson02 wrote:

    Such emotional speculators. If you have to go to such measures to cheerlead your stock so that it will do well, then you probably shouldn't have thrown money at it anyway. Good luck to you, but don't be surprised if it doesn't pan out.

  • Report this Comment On November 11, 2009, at 12:44 PM, loneyheart90125 wrote:

    tons of negative stuff about SIRI, deserved or not, can anyone tell me why neither the street or fool has a direct article/blog about ADVNB bankruptcy yet?

  • Report this Comment On November 11, 2009, at 7:15 PM, ItAintCool wrote:

    S&P Ups credit rating of Sirius

    ap

    S&P ups credit rating outlook of Sirius XM Radio

    S&P raises credit rating outlook of Sirius XM Radio, citing improving profitability

    * On 5:56 pm EST, Wednesday November 11, 2009

    o

    Buzz up! 1

    o Print

    *

    Companies:

    o Sirius Xm Radio Inc.

    NEW YORK (AP) -- A credit ratings agency on Wednesday raised its outlook on Sirius XM Radio Inc. and its subsidiaries, citing improving profitability.

    Standard & Poor's Ratings Services upped the company's credit rating outlook to "Positive" from "Stable." A "Positive" outlook means that Sirius XM's rating may be raised over the next six months to two years.

    S&P also affirmed the satellite radio company's B- corporate credit rating. The rating covers Sirius XM's overall creditworthiness and means the company currently can meet its financial obligations.

    Take that SiriDouche!

  • Report this Comment On November 12, 2009, at 2:37 PM, SIRIDoom wrote:

    LOL ok

    So why is SIRI still floating around 65 cents?

    could it be billions of debt?

    Slower growth, if any?

    or the pending rev-split?

    SIRI is still junk rated, avoid...

  • Report this Comment On November 13, 2009, at 7:20 PM, AllSpArK wrote:

    misther153, LVLT is a Tier One ISP (Internet Service Provider). Last time I toured their downtown manhattan facilities almost a decade ago, they had a flashy outfit. The tour ended at a command center which added to their WOW factor.

    I believe they are in the same business and provide ISP services. All major players have servers at most tier one ISP colocation facilities including guys like Yahoo and Google. Most of these ISPs connect to each other with dedicated fiber lines to ensure multiple routes to the same computers. That is how you get the Internet really <I>connected</I>.

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