Get Ready to Buy

"Small-cap stocks squash large-cap stocks like grapes."

That's how I planned to open this column. By now, I'd be making my case -- dropping obscure references like Nagel and Quigley and citing 70-plus years' of Ibbotson data.

And by ... now! My inbox would be over its size limit. "Your numbers are skewed by a few abnormal years," Jim from Long Island would be hollering, or "What about survivorship bias?" And he'd be right.

So forget the numbers
You don't need me (or an Excel spreadsheet) to prove to you that tomorrow's multibillion-dollar corporations are small, little-known companies today. It just stands to reason. The trick is distinguishing the winners from the also-rans without the benefit of hindsight.

The question is whether we can do it in time. It's not easy, but I think we can. I'll show you why I say so, but for now, just know that we will be looking for those rare smallish companies that are:

  • Run by entrepreneurial zealots with ownership stakes.
  • Free of convoluted relationships with banks.
  • Able to grow their sales and cash flow exponentially.

And there's something else: We're looking for a stock that hasn't hit Wall Street's radar yet. This way, we can benefit from pent-up institutional demand when earnings and revenues pick up, and the sell-side guys on Wall Street finally do catch on.

Now, what do I mean by "zealots"?
How about Apple's (Nasdaq: AAPL  )  Steve Jobs. Not now, but back in the day, when he had the audacity to go head to head with Bill Gates' Microsoft in the 1980s? Without that audacity, Apple would never have lived to see the iPod. Of course, the same could be said of Scott McNealy's Sun Microsystems (Nasdaq: JAVA  ) , which also took on the mighty Bill Gates.

This is nothing new. Decades earlier, Walt Disney essentially willed a tiny cartoon studio into a global Disney (NYSE: DIS  ) empire. Talk about zealous. You sense the same passion in Fred Smith, founder of FedEx (NYSE: FDX  ) , whose stock has risen some 20 times in value since 1980.

None of which means that finding these guys is easy, but it can be done. More than anything, we need to be patient, have a plan, and pick our spots. Even better, we can steal a page from Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems playbook, seeking out companies with market caps of less than $2 billion that offer:

  • Solid management with big stakes in the company.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

Just remember those five keys
Again, companies like that don't come along every day, but these five keys work. I already mentioned McNealy's Sun Microsystems. If you missed Sun Micro, you could have bought into Michael Dell's notion of selling computers direct to consumers, and done even better. Surely there are others like them lurking out there right now.

But what are your chances of finding the next home run stock? Probably not as good or as bad as you may think. Earlier, I mentioned Motley Fool co-founder Tom Gardner. I personally witnessed how those five keys led Tom and his team of analysts to better-than-225% profits in less than two years, when Shire (Nasdaq: SHPGY  ) snapped up a drug company called Transkaryotic.

Hidden Gems subscribers locked in another triple when GlaxoSmithKline (NYSE: GSK  ) took out tiny CNS, makers of the Breathe Right nasal strips. It was a similar story, on a smaller scale, when another Hidden Gems pick, Radyne Comstream, was bought out by a company called Comtech (NYSE: CMTL  ) .

So, you see, it can be done
I know it can seem like all the great ideas have been taken. But I hope you haven't given up on investing in innovative companies for the long term. If history is any guide, it will be small companies that will lead us out of this recession and into the next bull market. That's why I always have a wish list of great small caps on hand for times just like this. You should, too.

If you're short on ideas, or if you want to share some of your own, you should consider trying out Hidden Gems free for 30 days. You don't have to subscribe to anything, and you can take a whole month to decide if it works for you. Meanwhile, you can check out the entire portfolio of small-cap value picks and download every back issue in five minutes.

As investors, it doesn't pay to be too proud. We all need an edge and I've learned that there is comfort in sharing with other investors, especially when dealing with smaller companies. Take your time and be careful. Wait for a pullback if that makes you feel better, but get ready to buy. To learn more about this offer to try Hidden Gems free, simply 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. Walt Disney and Microsoft are Motley Fool Inside Value picks. Apple, Walt Disney, and FedEx are Stock Advisor recommendations. Motley Fool Options has recommended a diagonal call on Microsoft. The Fool owns shares of GlaxoSmithKline. The Motley Fool has a disclosure policy.


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