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Wall Street's Worst-Kept Secret

What's Wall Street's worst-kept secret? It's simple.

If you want to make money in stocks, you should look at small caps. It's a point of contention, but I'm convinced that, over the long haul, small-company stocks outperform mid and large caps.

You want an edge
Otherwise, you wouldn't be reading this. So, why make this more difficult than it has to be? Despite recent arguments to the contrary, spawned by the so-called lost decade, investors who make the most money over the long term don't hold cash or buy bonds, or even gold.

They buy and hold common stocks. At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who have wanted to make even more have at least dabbled in small caps, also according to Ibbotson.

Assuming that's true -- and that we still have the guts to buy and hold for the long term -- we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). 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 have the good fortune to enjoy the occasional chat with Tom Gardner. Tom, as you may already know, co-founded The Motley Fool with his brother David back in 1993. He has also made a career out of beating the Wall Street pros to well-run small companies.

And I'm man enough to admit that the team of analysts Tom has assembled at Motley Fool Hidden Gems is building a portfolio of small-cap stocks that I probably wouldn't have found on my own. What's their secret? I think it's that Tom's guys focus on value, while I have always loved a good story.

Yet for all our differences in approach, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. A long line of smart investors have beaten the market by looking for:

  • 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 these traits gave early investors the courage to follow Larry Ellison into Oracle (Nasdaq: ORCL  ) -- a one-time software start-up that in the late '90s went on to battle Pfizer (NYSE: PFE  ) and General Electric (NYSE: GE  )  for the top of the market-cap heap.

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like Oracle (or even GE)? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those are now -- if they're really all that, they're going to cost you.

So, what are you going to do? Take a chance on some fly by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference. Harley-Davidson (NYSE: HOG  ) , for instance, had a cult following for years, but it was one of the great stealth stock stories of the 1990s. Ditto for Coach (NYSE: COH  ) -- a stock I own myself -- after being spun off from Sara Lee (NYSE: SLE  ) at the beginning of this decade.

Or compare Southwest Airlines with JetBlue (Nasdaq: JBLU  ) . Neither fits the mold now, but at one time or another, both satisfied most of Tom's Hidden Gems criteria. Yet JetBlue, you'll recall, was a hot stock out of the gate. Southwest was a cult favorite and took years to register a blip on Wall Street's radar. Which would you rather own now?

Here's one more idea
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet you won't hear many of those names from your broker. And that's no coincidence -- though you might very easily recognize Green Mountain Coffee Roasters from "real life."

Put it altogether and you see our edge: We can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these companies, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% per year on average.

Here's some more personal advice
Go ahead and test 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 guys tell you about each month in his Hidden Gems newsletter. Sooner or later, you want to be exposed to at least a few small businesses with big potential -- remember those names I mentioned earlier.

Even better, if you want to learn more about how Wall Street's worst-kept secret can help you beat the pros, think about this: You can take a free trial to the complete Hidden Gems service right now. You can view all the picks immediately and look on as the team invests in a real money portfolio (already two of their holdings have doubled since they launched the portfolio in March 2009).

You can even read and print out every one of his back newsletter issues, if you like. Best of all, the first month is on me, and there's never any pressure to subscribe, no matter how much you've used the service. I've been saying I haven't seen a market this suited to small caps since 2003. I bought it then, and I'm buying now. To learn more about trying Hidden Gems for free, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P 600 Growth Index, the iShares S&P 600 Value Index, Pfizer, and Coach. Coach is a Stock Advisor recommendation. Green Mountain Coffee Roasters is a Rule Breakers pick. Pfizer is an Inside Value pick. You can view the entire Motley Fool Hidden Gems scorecard with your free trial. The Motley Fool has a full disclosure policy.

Read/Post Comments (7) | Recommend This Article (6)

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 January 17, 2010, at 9:12 AM, mattskin wrote:

    It's remerkable how you can usually guess which MF product 90% of the articles are pitching by the end of the first paragraph.

  • Report this Comment On January 17, 2010, at 9:13 AM, TryFoolish wrote:

    Logical thinking and fundamentals are old game to make money in stock market. Current market is on Govt. Aided Sterroids. My gut feeling is market will pull back 5%-10% and come back up and stablize in current levels until the Mid-term election. So the Ploiticians can claim success, their new policies are working and helped recovery and use it for election campaign. Real colors show up after the mid-term election. Until then Fundamentals and logical analysis won't apply to any companies.

  • Report this Comment On January 17, 2010, at 12:21 PM, 3percenthero wrote:

    Just more BS I usually try and skip these types of posts as I just get pissed off when I realize it was just waisted time and there is no real content in them. This can usually be picked up in the lead in but occasionally I'll bite.

  • Report this Comment On January 17, 2010, at 12:26 PM, TLassen wrote:

    "What's Wall Street's worst-kept secret? It's simple.

    "If you want to make money in stocks, you should look at small caps. It's a point of contention, but I'm convinced that, over the long haul, small-company stocks outperform mid and large caps"

    what nonsense.

    What's Wall Street's worst-kept secret?

    Too many noise makers on both buy and sell sides desperately craving attention and peddling their products

  • Report this Comment On January 17, 2010, at 6:02 PM, ozzfan1317 wrote:

    Its hard to argue that small caps with room for strong growth offer more upside. However you should always consider a strong opportunity wether it be value or growth.

  • Report this Comment On January 18, 2010, at 7:49 PM, Fool wrote:

    I don't understand this Motley Fool. I mostly think they are trying to influence the market for their own gain. People, make your own decisions. Don't trust what you read.

  • Report this Comment On January 18, 2010, at 7:56 PM, Fool wrote:

    I know, it's as if I was shorting a company's stock, and published something that said, "Xyz's financials are horrible!". Some Db is gonna believe it and it becomes self fullfilling and profitable.

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