Crush the Market in the Next Decade With These Stocks

It's often assumed that the deck is stacked against individual investors like you and me. And to a certain extent, it is. The big investment houses such as Goldman Sachs have their tentacles in all kinds of businesses, so they get a first reading on the direction of the economy before we're ever able to. They can exchange shares lightning-quick with high-frequency trading, profitably skimming fractions of pennies off the top of every trade.

But, amazingly, these are some of the few advantages that such institutions have. In its very structure, Wall Street perpetuates gross inefficiencies, leaving pockets of immense opportunity for enterprising individuals. In fact, as individuals we have much greater opportunities, because we can buy the high-growth stocks that Wall Street can't touch.

You can outperform
Finance heavyweights Eugene Fama and Kenneth French discovered that every year, 1 in 8 small-cap growth stocks becomes large. According to these researchers, such soon-to-be large companies return up to 62% annually on average.

You would think Wall Street would have its hooks all over these stocks, quickly driving profits away, but the large funds are mostly unable to touch these stocks. Because they have so much capital, they have to focus on only the biggest and most liquid names, such as Bank of America, Citigroup, and Microsoft, which can trade hundreds of millions of shares per day.

Surprisingly, even mutual funds focused on small companies often are unable to cash in on the big gains offered by these hidden gems.

Why?

It's the so-called institutional imperative. Just as these stocks are about to hit the big time and score fat returns, small-cap funds usually have to dump them. The funds are often legally obligated to maintain a focus on small caps and typically can hold only a few larger stocks. That's the kind of inefficiency that leaves a gaping opportunity for individual investors. Because that inefficiency is consistently structured into the institutional system, it offers a reliable opportunity to find the home run stock of the next decade.

Consider the example of T. Rowe Price's New Horizons fund, which is focused on rapidly growing small caps. In 1970, the fund had picked up shares in the recent debut Wal-Mart (NYSE: WMT) debut. Of course, the retailer grew like gangbusters, and by 1983 it had outgrown its small-company classification. Now, the rational approach would be to hold on to (or even buy more of) such a hot prospect, but what did the fund do because of its institutional imperative?

It sold, of course. If the New Horizons fund had simply held its shares, they would now be worth $14 billion, or twice the current value of its entire portfolio! Of course, today Wal-Mart is so huge that it simply doesn't have the same ability to grow; recent quarters show a retailer that is struggling to produce positive same-store sales, a key metric for the sector. But that wasn't true at the time New Horizons had to sell.

Individual investors are not forced to sell just because a company grows too large, and that's one of our key advantages as individual investors. That may seem like a tiny edge, but when you can find rapidly growing small caps, it's a huge leg up, as an accidental millionaire could tell you.

Grow to the sky
Wal-Mart's not just some one-off example, though. The only place to find such super growth is in the market's undiscovered stocks. Look at how a few stellar small caps have performed in the past decade:

Source: Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

If you're looking for small caps that will become huge, pay attention to strong sales growth and high returns on equity, a measure of how profitably the company uses shareholders' capital. Those two metrics show that a company's products are in demand and that it can sell those products profitably. Outstanding results in both metrics over time will turn small caps into large caps, bringing wealth to shareholders.

While natural-gas producer XTO has been so successful that ExxonMobil is now buying it out, Hansen and Deckers could have room to run. But don't just look at past results. Consider how the products might fare in the future, and beware especially of fads.

Deckers has worked its Ugg brand for immense profit for quite a few years. Because it derives nearly 70% of its total sales from Ugg, any stumble there could truly hurt the company. But consumers are fickle, and highly specialized items such as fashionable footwear could die out fast. Just ask investors in Crocs (Nasdaq: CROX). After seeing revenue more than double from 2006 to 2007, sales plummeted by 24% from 2007 to 2009. The supplier of once-cool plastic footwear saw its stock crash by more than 80% since its late 2007 high. And while sales have improved marginally in 2010, fads never truly come back.

In contrast, the energy-drink market has been of immense interest not only to Hansen and Red Bull, but also much bigger players such as Coca-Cola. That interest from a giant such as Coke suggests that this market will not be a fly by-night fad. Hansen continues to expand its energy drinks into huge new markets such as Germany and Brazil.

Notice, too, how return on equity for Hansen and Deckers ramped up as they grew, a great signal that they were becoming more efficient at squeezing profit out of their businesses.

Watch out for businesses that boost their profitability with too much debt. The three companies above have used debt prudently, and Hansen and Deckers have no debt. The liberal use of debt can boost return on equity and make the business look more profitable. So don't ever look at return on equity in isolation.

Here are two small-caps that boast robust returns on equity, low debt levels, and high sales growth.

Source: Capital IQ.

Buffalo Wild Wings has been expanding into a national chain, and despite a same-store-sales decline in the most recent quarter, the company is still projecting as much as 20% earnings growth for the year. Its expansion, fueled solely by cash from its operations, continues apace.

Under Armour has been successfully competing in the athletic world with its performance apparel, and it has recently expanded into shoes, where it's trying to score on the industry's big dogs, such as Nike. Under Armour has been expanding its sales outlets from traditional sports retailers to department stores and expanding its own retail chain to capture higher margins from customers.

So where are the decade's next home run stocks hiding?

The household names of tomorrow
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Jim Royal, Ph.D. , owns shares in Microsoft and Bank of America. Microsoft and Wal-Mart Stores are Inside Value picks. Hansen Natural and Under Armour are Rule Breakers recommendations. Buffalo Wild Wings and Under Armour are Hidden Gemsselections. Coke is an Inside Value and Income Investor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Under Armour and XTO Energy and has a disclosure policy.