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Wall Street's Worst-Kept Secret

Ignore what you've heard about the so-called death of buy-and-hold investing. It's nonsense. Until someone proves to me otherwise, U.S. investors who will make the most money over the long term will invest in common stocks.

They certainly have since Ibbotson Associates started keeping tabs back in 1926. Investors who want to make even more hold their share of small-company stocks in their portfolios, also according to Ibbotson.

The way I see it, we have three choices. We can roll the dice on a small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF) -- more on that later. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we prefer to do it ourselves. Sort of. You see, I recently chatted with Motley Fool co-founder Tom Gardner -- a pretty successful investor who has a reputation for finding well-run small companies ahead of the Wall Street crowd.

And you know what? I'm beginning to think that Tom and the analysts he recruited to manage his Motley Fool Hidden Gems small-cap investment newsletter service are on to something. Frankly, they are building a portfolio of small companies I wouldn't have found on my own.

What's the secret? I think it's that these guys focus on fundamentals, while I get sucked in by a good story. And they're extremely thorough, too. Before they pass a recommendation on to their subscribers, they run literally dozens of potential prospects through a checklist, looking for:

  1. Solid management with significant stakes.
  2. Great, sustainable businesses.
  3. Dominant positions in niche markets.
  4. Sterling balance sheets.
  5. Strong free cash flow.

Good work if you can get it
I know what you’re thinking. Who wouldn't want a portfolio filled with companies like that? That's precisely the problem with trying to beat the pros with well-known, large-cap stocks -- if they're really all that, they're going to cost you.

So, what are you going to do? Take a chance and risk your money on some fly by-night outfit? Point taken. But notice I said well-known, large-cap stocks -- not companies. This is an important distinction best illustrated with a few examples.

Google (Nasdaq: GOOG  ) , you'll recall, was a verb years before it was a stock. Yahoo! (Nasdaq: YHOO  ) , meanwhile, seemed to hit Main Street and Wall Street at the same instant. Yet in each case, the stocks were crawling with Wall Street analysts before you or I could ever hope to get an edge. In other words, Google and Yahoo! were story stocks.

But that's not always the case
Consider teen retailers PacSun (Nasdaq: PSUN  ) and American Eagle Outfitters (NYSE: AEO  ) . Dozens of analysts cover them now, but most investors heard about those companies from their kids, not their brokers. That's when the real money is made. And those are just two examples of small, proven businesses with solid fundamentals that flew beneath Wall Street’s radar.

More important, there's always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Peter Lynch was a master at finding them. In fact, it was Wall Street outcasts like Gap (NYSE: GPS  ) and Taco Bell -- now part of massive Yum! Brands (NYSE: YUM  ) -- that helped earn Lynch's Fidelity Magellan fundholders nearly 30% year after year.

We can do it, too
To prove it, my colleague and former Hidden Gems contributor Tim Hanson tracked down the best-performing stocks of the past 10 years. Check them out here. But don't expect to find story stocks and familiar names on the list. Instead, look for solid businesses that started as underfollowed stocks. For example, there's mid-tier biotech Celgene (Nasdaq: CELG  ) , which rode a few key drugs to 4,167% gains over 10 years.

Don't get me wrong; these companies aren't easy to find. But I hope you can see how this is great news for investors like us -- especially after all we've been through this year. These examples prove that we can find established, profitable companies with unknown stocks and ride them to big profits. Some you will have heard of; others you may not have -- yet.

As for finding the next Peter Lynch, a word of warning: Beating the market with a mutual fund is a crapshoot. That's why I like ETFs -- you get quick, broad exposure to an entire group (like small caps) without the performance-sucking management fees associated with managed funds. I own both the iShares S&P SmallCap 600 Growth (IJT) and Value (IJS) indexes myself.

Here's a better idea
If you ask me, a strategy of starting with these ETFs and scaling gradually into the stocks you’ll hear about each month in the Motley Fool Hidden Gems newsletter is a winner. After all, you want to be diversified, but sooner or later, you'll also want a little more exposure to great small businesses with massive potential.

And, yes, I do think you still have time to catch the next leg higher – though it’s time to be selective. If you're ready, but need some good stock ideas to get rolling, why not accept a free trial of the complete Hidden Gems service? You can check out every current and past recommendation and view their real-money portfolio in its entirety (the team is investing $250,000 in their top picks).

You can even read all the newsletter issues online -- and print them out and keep them if you like. There's no pressure to subscribe, and your first month is on me. To learn more and have a look, 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. Google is a Rule Breakers recommendation. You can view the entire Hidden Gems scorecard instantly with your free trial. The Motley Fool has a full disclosure policy.

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  • Report this Comment On December 14, 2009, at 8:04 PM, plange01 wrote:

    worst kept secret? the size of their bonuses of course and this year much of it made with taxpayers money and with the help of obama who approved the whole stinking mess...

  • Report this Comment On December 15, 2009, at 2:06 PM, sid2286 wrote:

    I think that the whole thing was a mess long before Obama got into a position where he could do anything. Lets not forget that he has been in power less than a year, whereas the Great Recession has been happening for about 2-3 years now. Also, could you use punctuation next time you rant randomly on a MF article, it kinda hurts the point that you are trying to make. Thanks.

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