"Over the years, small-cap stocks crush their large- and mid-cap peers."
That's how I planned to start this column today. By now, I'd be proving my case -- dropping names like Nagel and Quigley and citing 70 years' worth of Ibbotson data.
And by ... now! my inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be shouting, or "What about survivorship bias?" And you'd be right. That's the fatal flaw with relying on historical data: The future is not the past.
So forget the numbers
Fortunately, you don't need an Excel spreadsheet to prove that tomorrow's megacaps are mostly smaller companies today. But if you want to find them ahead of the crowd, you do need a few clues. History tells us we're looking for a smallish company (probably less than $2 billion) ...
- Run by entrepreneurial zealots with ownership stakes.
- Free from convoluted relationships with investment banks.
- Able to rapidly grow sales and cash flow.
And one more thing: You want a company whose stock hasn't hit Wall Street's radar yet. That way, you can benefit from pent-up demand when earnings and revenue pick up and the sell-side analysts finally catch on.
So, what exactly is an "entrepreneurial zealot"?
Well, how about John Rockefeller? Sounds crazy, I know, but you can trace ExxonMobil (NYSE: XOM ) , one of the largest companies in the world, to his Standard Oil. A little too dusty for you? Fair enough. How about Larry Ellison's work at Oracle (Nasdaq: ORCL ) in the 1990s?
In the 1970s, a guy named Fred Smith launched FedEx (NYSE: FDX ) using a college paper as his blueprint. A few years before, Robert and Bruce Toll started a construction company called Toll Brothers (NYSE: TOL ) , now one of the nation's premier builders. You see where I'm going.
You never had to check these guys' insider holdings to know they had huge stakes in their businesses. And, thankfully, there's another one born every day -- contrary to what the naysayers and America-bashers would have you believe. That's the beauty of capitalism.
That's not to say that finding them is easy, but it can be done. More than anything, we need to be patient and pick our spots. Even better, we can take a cue from my boss Tom Gardner's Motley Fool Hidden Gems method and seek out companies that have market caps of less than $2 billion that offer:
- Solid management with big stakes in the companies.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
Just remember those five keys
In the 1990s, they led Peter Lynch disciples to a kid retailer called American Eagle Outfitters (NYSE: AEO ) -- a stock that I watched pack on more than 10 times its original value over a decade and a half. One in a million, you say? Not exactly.
The same thing happened with Chico's FAS (NYSE: CHS ) , a more mature clothes hound that delivered monstrous gains to early investors. And then there's Seattle's other best, Nordstrom (NYSE: JWN ) , a more upscale retail multibagger.
So if you're looking for companies that will not only make it through the current recession but also have the potential to help you recoup your recent losses, start with those five keys.
Think we've come too far, too fast?
You may be right. There is no shame in waiting for a pullback. But I wouldn't wait too long. It's tough to time the market just right, and Warren Buffett is right when he says that cash is a horrible long-term investment. That's why I'm buying.
That's also why I always have a wish list of great small companies on hand for times like this. You should have one, too. Here's an idea: Do what I do -- lean on the team of advisors at Hidden Gems for ideas and advice. They've never led me wrong.
And right now, you can sample the entire service free for a whole month. You can even look on as the team invests $250,000 in real money -- so there's no guesswork. Best of all, if you're not impressed at any point during your 30-day trial, I'll personally make sure you don't pay a dime. Even Buffett would be proud. To learn more about this free trial offer, click here.
This article was originally published May 10, 2005. It has been updated.
Paul Elliott does not own shares of any company mentioned in this article. You can see the entire Hidden Gems scorecard, including every active and past recommendation, with your free trial. FedEx is a Stock Advisor recommendation. The Motley Fool owns shares of Oracle and has also written puts on Oracle. The Motley Fool has a disclosure policy