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 Research In Motion (Nasdaq: RIMM ) , Merck (NYSE: MRK ) , Coca-Cola (NYSE: KO ) , 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 past 10 years, weight-loss company Medifast, was better than a 90-bagger. Even at 90 times its original market capitalization, Medifast is just a $500 million company; Research In Motion is 70 times bigger, Merck is 200 times bigger, and Coca-Cola is 250 times bigger.
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 are former blue chips AIG (NYSE: AIG ) , Citigroup, and Fannie Mae (NYSE: FNM ) . If they recover, each could be a multibagger from here. However, they're all priced at fractions of their former highs because each faces a huge "if." At this point, they're speculations more than investments.
Meanwhile, small caps are a little different. Because 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
Let me take you back to fall 2008 and restaurant company Buffalo Wild Wings (Nasdaq: BWLD ) . In late October, it reported quarterly earnings that were disappointing. But given the state of the economy in general (read: panic) 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 those months, it remained the same company with the same long-term prospects. There were no huge company-related events, and its price was about the same a few months after the earnings release as it was a few months before.
But somewhere in the middle, the market threw a half-off sale for investors patient enough to wait for a discounted entry point. Because they took advantage of volatility, those investors need only a five-bagger (or less) 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.