Get Ready to Buy

"Over the years, small-company stocks -- and the investors who buy them -- crush their large- and mid-cap peers."

I had every intention of starting this column with that gross generalization. By now, I'd be making my case – waving charts, dropping obscure names like Nagel and Quigley, and banging the table on 70-plus years' worth of Ibbotson data.

And by ... now ... my inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be hollering, or "What about survivorship bias?" And, of course, you'd be right. That's the fatal flaw with relying on historical data: The past does not always repeat itself.

So forget the numbers
Fortunately, you don't need an academic study or even an Excel spreadsheet to prove that tomorrow's household names are relatively unknown smaller companies today. It just stands to reason. What you may need, however, is a proven method to help you find them before the big money is made. There are no guarantees in the markets, but if history is any guide, we're looking for a smallish company ...

  1. Run by entrepreneurial zealots with ownership stakes.
  2. Free of convoluted relationships with investment banks.
  3. Able to grow its sales and cash flow exponentially.

And one more thing: Our odds of hitting one out of the park increase dramatically if we can find a stock that hasn't hit Wall Street's radar yet. That way, you're positioned to benefit from pent-up demand when earnings and revenues pick up, and the sell-side analysts start piling on.

But what do I mean, "zealots"?
How about David Filo and Jerry Yang? If you don't recognize their names, I'll bet you know their company, Yahoo! (Nasdaq: YHOO  ) . And then there's Jeff Bezos, whose name you probably do recognize. His work at Amazon.com (Nasdaq: AMZN  ) made him Time's Person of the Year, for Pete's sake.

Think about it. You don't need to check these guys' SEC filings to know they have huge stakes in their businesses -- or see a stock chart to know they all made early investors a ton of money. And here's some more good news: There's one born every day. That's the beauty of the stock market, after all. Even if we're not geniuses ourselves, we can hitch our wagons to those who are.

All of which is not to imply that finding these guys is easy, but it can be done. More than anything, we need to be patient and pick our spots. Even better, we can take a cue from Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems method and seek out companies with market caps of less than $2 billion that offer us:

  1. Solid management with big stakes in the company.
  2. Great, sustainable businesses.
  3. Dominant positions, preferably in niche markets.
  4. Clean balance sheets.
  5. Strong free cash flow.

Just remember those five keys
Again, they don't come along every day, but they really do work. Digging around this morning, I was shocked to find that unassuming Lowe's (NYSE: LOW  ) is up more than 20 times since 1990. Starbucks (Nasdaq: SBUX  ) , a Motley Fool favorite since the mid-'90s, also made a killing for early investors. Two in a million, you say? Maybe not.

Love him or hate him, much the same happened with Rupert Murdoch's News Corp. (NYSE: NWS  ) . If you're more of a techie, you could have followed security mastermind Denis Coleman into Symantec (Nasdaq: SYMC  ) and done just as well. There's more.

The five keys I just showed you also led the team of analysts that Tom Gardner assembled at Motley Fool Hidden Gems to a quick double on China travel agent Ctrip.com (Nasdaq: CTRP  ) , one of more than two dozen recommendations that have doubled or more since Gardner launched his project in 2003.

So has this market topped?
Nobody can say for sure. But I'm glad you didn't follow the shrill advice and give up on stocks last March. And if history is any guide, small companies will continue to lead us out of the recession. That's why I have a wish list of great small companies on hand. You should, too. If you're short on ideas or need a little help getting started, here's another great opportunity:

You can try out Motley Fool Hidden Gems free for 30 days. You don't have to subscribe to anything, and you can take all that time to decide if it works for you. Meanwhile, you can check out the entire real-money portfolio of small-cap value picks and download every back issue right now.

As investors, it doesn't pay to be too proud. We all need an edge and there's safety in numbers, especially in markets like this one. Be careful and wait for a pullback if it makes you feel better -- but I hope you won't risk missing out on the next bull market. 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. Lowe's is a Motley Fool Inside Value recommendation. Amazon.com and Starbucks are Motley Fool Stock Advisor selections. Ctrip.com International is a Motley Fool Hidden Gems pick. The Motley Fool has a disclosure policy.


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