Get Ready to Buy

"Small-cap stocks squash large caps like grapes" – especially coming out of recessions.

That's how I planned to soften you up today. 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," you'd be hollering, or "What about survivorship bias?" And you're right. That's the fatal flaw with all historical data:

It's just a bunch of numbers, frankly, and the future resembles the past at best.

So forget the numbers
You don't need me (or an Excel spreadsheet) to tell you that many – if not all -- of tomorrow's multibillion-dollar corporations are small, relatively unknown companies today. It just stands to reason. The trick is distinguishing the winners from the bombs without the benefit of hindsight.

Can we do it? It's not easy, but I really think we can. I'll show you why I say so, but for now, just know that we are looking for those rare smaller 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: You want a stock that hasn't hit Wall Street's radar yet (or even Mad Money, best case). This way, you 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? Maybe not so much now, but back in the day, when he had the audacity to go head to head with another zealot, Bill Gates and his little company called Microsoft (Nasdaq: MSFT  ) in the 1980s? Without that audacity, Apple might 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 Gates. This is nothing new. Decades before, Walt Disney essentially willed a tiny cartoon studio into a global Disney (NYSE: DIS  ) empire. Talk about nutty -- I mean, 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 companies ahead of the crowd 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 strategy, 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.
  • Clean 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 is another like them lurking out there right now.

But, seriously, 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 tiny 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 (a stock I owned myself), was bought out by Comtech. All told, the Gems team has dug up 20 small companies that doubled in value or more. So, you see, it can be done.

Yes, even in this market ...
Seriously, I hope you haven't given up on investing in innovative companies for the long term. If history is any guide, it is small companies that are quietly leading us out of this recession right now -- and into the second leg of the new bull market. That's why I always have a wish list of great small caps on hand. You should, too.

If you're short on new 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 fits your style. Meanwhile, you can check out the entire portfolio of small-cap value picks, see what the team is buying right now for its real-money portfolio,  and even download (or print) every back issue in five minutes.

As investors, it doesn't pay to be proud (or too cautious). We all need an edge, and I've learned that there really is comfort in numbers, especially in uncertain markets like this one. Take your time and wait for a further pullback if it makes you feel better. But don’t wait too long, and give up on stocks at your own risk. 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 own Disney. FedEx, Apple, and Disney are Stock Advisor recommendations. Disney is also an Inside Value pick, as is Microsoft. GlaxoSmithKline is an Income Investor choice. The Motley Fool has a disclosure policy.


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