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Wall Street's Worst-Kept Secret

Technically, I'm not allowed to give you personal investing advice in this column. But if I was, I'd say something like this ...

Despite all this talk of bubbles and "lost decades," investors who make the most money over the long term invest in common stocks -- not bonds, not gold, not even real estate.

At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who make even more invest some portion of their money in small-company stocks, also according to Ibbotson. Of course, that's not personal investment advice -- that's Wall Street's worst-kept secret.

The way I see it, there are few ways we can play this long-term trend right now. We can roll the dice on a small-cap mutual fund, if we can find a good one accepting new money. We can buy a small-cap exchange-traded fund (ETF) -- I've owned a few myself for years. 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 recently had the pleasure of discussing the benefits of investing in small-company stocks with Motley Fool co-founder Tom Gardner -- a guy who made a career out of digging up well-run small companies ahead of Wall Street.

I'm beginning to suspect that Gardner is onto something, and that the team of analysts he handpicked to run his Motley Fool Hidden Gems small-cap advisory service is building a portfolio of small companies I probably couldn't have found on my own.

How do they do it? I think it's that, when digging up well-run small companies, these guys focus on fundamentals, while I tend to get wowed by story. To make sure they stay on track, they have a checklist of important criteria they measure their potential targets against, including:

  • Solid management with significant ownership stakes.
  • Great, sustainable businesses.
  • Dominant positions in important niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

I know it's hard to imagine now, but many of these same traits gave investors the courage to follow a young man named Howard Schultz into Starbucks (Nasdaq: SBUX  ) . The same goes for Sam Walton and Wal-Mart back in the 1970s. Both were incredibly profitable investments for many years.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own names like Starbucks and Wal-Mart -- at least in their prime earning years? And you're right. That's why it's so hard to beat the pros with familiar stocks like those when they're hot; if they're really all that, they're going to cost you.

But what are you going to do? Take a chance on some fly by-night outfit? Good point. But notice we've been talking about well-known stocks -- not necessarily well-known companies. Of course, there's a difference.

Take a flashy tech outfit with a sexy name like Level 3 Communications (Nasdaq: LVLT  ) or Tellabs (Nasdaq: TLAB  ) . These were familiar tickers long before many traders figured out what they actually do. Companies like BJ's Wholesale Club (NYSE: BJ  ) , on the other hand, have strong regional or even national footprints long before they hit Wall Street's radar.

Need more proof?
Check out my buddy Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of story stocks like Sirius XM Radio (Nasdaq: SIRI  ) or Suntech Power (NYSE: STP  ) . In fact, I'm willing to bet you haven't heard of more than one from your broker, though you might recognize a bunch from "real life" -- Green Mountain Coffee Roasters (Nasdaq: GMCR  ) , for example.

And that's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these gems. That's a big part of how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, beating the market with an actively managed mutual fund is always a crapshoot. That's why I'm a fan of exchange-traded funds (ETFs) -- you get broad exposure to the entire group without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth Index (IJT) and the value index.

Some more personal advice
Consider testing 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. Diversification is great, but sooner or later, you want to be exposed to at least a few small businesses with big potential.

Even better, if you're curious about how Wall Street's worst-kept secret can help you beat the pros, think about this: Look into accepting a no-risk free trial to the complete Motley Fool Hidden Gems service. You can print out every back issue and check out all the recommendations in five minutes.

You can even look on as the team builds a real-money portfolio of small-cap stocks. Best of all, the first 30 days is on me, and there's never any pressure to subscribe. Despite the rally last year, I haven't seen a market better suited to small caps since 2003. I loaded up then, and I'm buying now. I hope you'll join me. 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 and the iShares S&P 600 Value Index, but no other securities mentioned in this article. You can see all the Hidden Gems recommendations with your free trial. Starbucks is a Motley Fool Stock Advisor pick. Wal-Mart is an Inside Value pick. Suntech Power and Green Mountain Coffee Roasters are Rule Breakers choices. The 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 February 17, 2010, at 9:21 AM, looserstreet wrote:


    Bid 1.01

    Open NA Bid Size 69,200

    Day's High NA Ask 1.02

    Day's Low NA Ask Size 48,300

    Volume 3.27 Mil 52 Week High 0.98

    Avg. Daily Vol. (13 wk.) 37.45 Mil 52 Week Low 0.12

  • Report this Comment On February 17, 2010, at 9:24 AM, looserstreet wrote:

    Bid 1.01

    Open NA Bid Size 69,200

    Day's High NA Ask 1.02

    Day's Low NA Ask Size 48,300

    Volume 3.27 Mil 52 Week High 0.98

    Avg. Daily Vol. (13 wk.) 37.45 Mil 52 Week Low 0.12

  • Report this Comment On February 17, 2010, at 11:46 AM, 55000 wrote:

    you fools at fools missed a buying opportunity on sirius......didn't you?

  • Report this Comment On February 17, 2010, at 12:53 PM, Ironbob wrote:

    So how much did Stern pay you to post that?

  • Report this Comment On February 17, 2010, at 1:33 PM, Koeikan wrote:

    I love it. I bought SIRI at 11 cents (and was tempted to buy more at 6 cents, but realized that was crazy thinking).

    Anyway, being a stockholder and a reader of this site did not go well together. Even after it looked like things were really turning around, the fools here tried to keep it down. I wouldn't be surprised if there was a conflict of interest somewhere, because the coverage was so stacked against it.

    I'm just glad I didn't listen to any opinions I didn't agree with...

  • Report this Comment On February 17, 2010, at 1:35 PM, Koeikan wrote:

    @Ironbob: When your return for the year on a stock is starting to approach 1000%, you don't need anyone to pay you to post...but I guess you wouldn't understand.

  • Report this Comment On February 17, 2010, at 1:39 PM, ItAintCool wrote:


    LMAO@SIRIDouche - "Reverse Split!" "Reverse Split!" - Where are you buddy? We miss you!


    LMAO@Jim Cramer & The Street

    Until 3Q almost all you guys all thought SIRI would tank or have to reverse split (some even continue to this day)! Too late to join the bandwagon when it was in the single and low double digits. MF, Still keeping your CAPS rating low while many other traders are optimistic on the company, not only to succeed, but to pay back their debts.

    I expect some profit taking before the end of the day, but I'm sure the stock will stay above $1.00 for the next 2 weeks.

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