Hey buddy! You want some personal investment advice?
If you own stocks, you should own some small caps. OK, that's not really personal investment advice. It's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you more money.
You're serious about this
You want an edge. So why make this difficult? History tells us that investors who make the most money over the long term buy and hold common stocks.
At least they have since Ibbotson Associates started keeping track back in 1926 (and yes, I think it's still true, in spite of the so-called lost decade). Investors looking to earn even more own small caps, also according to Ibbotson.
The way I see it, we have a few choices. We can take a chance and pay up for an actively managed small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF) -- I own two myself. 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 occasional cup of joe with my old friend and colleague Tom Gardner, co-founder of The Motley Fool -- a guy who has made quite a career out of beating Wall Street to profits on small, well-run companies.
And you know what? I can admit that Tom and the team of analysts he hand-picked to manage his Motley Fool Hidden Gems real-money portfolio service are methodically building a portfolio of small caps I couldn't have found on my own. What's their secret?
I think it's that they focus more on value, while I tend to get wowed by a great story. For all of that, we do look for many of the same things in a great small company:
- Solid management with significant stakes.
- Sustainable businesses.
- Dominant positions in niche markets.
- Solid, low-debt balance sheets.
- Strong free cash flow.
As hard as it is to imagine now, these traits led investors to a guy named John Morgridge and his Cisco Systems (Nasdaq: CSCO ) back in my day; even Jim Sinegal and Costco (Nasdaq: COST ) . I don't have to tell you how those investments worked out for early investors.
Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least in their prime? And you're right. That's why I think it's so hard to beat the pros with familiar stocks like those now; if they're really all that, they're going to cost you.
But what are you going to do instead? Take a chance on some fly-by-night outfit? Also a good point. But you'll notice that I said familiar stocks – not necessarily familiar companies. There's an important, yet subtle, difference if you think about it.
To see what I mean, consider big retailers Target (NYSE: TGT ) and Lowe's (NYSE: LOW ) . They're both heavily owned by institutional investors now, but that wasn't always the case. I remember a time when both had strong regional and even national bricks-and-mortar footprints, yet very little following on Wall Street.
Need more proof?
Check out The Motley Fool's Tim Hanson's list of the best-performing stocks of the past 10 years. You might be surprised to find that "widely helds" like Dell (Nasdaq: DELL ) or Microsoft (Nasdaq: MSFT ) don't make the list. Though you might easily recognize a company like juice-drink maker Hansen Natural (Nasdaq: HANS ) from "real life" -- just as you'd probably shopped at Target and Lowe's, before they became Wall Street darlings.
Of course, that's our edge. We find established, profitable companies whose stocks are relatively unknown. Some you have heard of; some you may not have. Peter Lynch was a master at digging up these undiscovered gems. That's a big part of why he earned his Fidelity Magellan fundholders an average of nearly 30% a year.
Here's some more personal advice
If you agree that what I say makes sense, I'd recommend you test the waters with a low-cost small-cap index fund like iShares S&P 600 Small-Cap Value Index (IJS). Then you can shift gradually into the stocks Tom Gardner's team tells you about each month in his Motley Fool Hidden Gems newsletter.
Or if you're eager to get started right away, why not check out the small-cap value stocks the team is buying right now for its own real-money portfolio? Best of all, you can try the complete Hidden Gems service free.
You can even print out every back issue, if you like. And there's never any pressure to subscribe. Honestly, I haven't seen a market better suited to small-cap investors since 2003. I bought then, and I'm buying now. I hope you'll consider doing likewise. I also encourage you to learn more about trying Hidden Gems for free -- simply click here.
This article was originally published Jan. 7, 2005. It has been updated.
Paul Elliott owns shares of the iShares S&P Small-Cap 600 Growth Index and the iShares S&P Small-Cap 600 Value Index. Amazon.com is a Motley Fool Stock Advisor pick. Dell and Microsoft are Inside Value choices. Hansen Natural is a Rule Breakers selection. The Fool owns shares of Costco. Motley Fool Options recommended diagonal calls on Microsoft. The Motley Fool has a full disclosure policy.