The Case Against Small Caps

Remember when people used to tell stories about the guy they knew who retired at 35 after getting a hot tip on Intel (Nasdaq: INTC  ) in the mid-1980s? Good times.

Or how about the joker who bought Adobe (Nasdaq: ADBE  ) and did even better? But that sword always cut both ways, right? How come nobody talks about the less-fortunate chumps who get wiped out when their hot stock tip suddenly goes belly up?

After all, that's the "problem" with buying small-company stocks, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School, and they'll tell you the same thing. Be sure to pack a few hundred grand in small bills, though. Or save yourself some money and consider something else. What if the defect isn't with small-cap stocks, but with small-cap investors?

What if the problem with small caps is that they attract a bad crowd? Maybe all those gamblers and daredevils, vying for the next home run, simply create the "illusion" of a wacky and treacherous market.

Don't take my word for it -- reams of data support that contention. But here's something more important than any piece of data: how you can use this "illusion" to make money.

Why small-cap investors get creamed
Any finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to come by, especially when times get tough -- like they are right now.

All true, but I'm not convinced that's why so many small-cap investors lose their shirts. It's more insidious than that. It's because they don't invest. Instead, they speculate on stock tips and high-risk story stocks with low-quality -- or worse, no -- real earnings. It's that simple.

Too many small-cap investors ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small, unknown company at a party or on TV, and he wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who fuss over mature large-cap, cigar-butt-and-smokestack companies trading at bargain prices. Could these guys be more boring? They never talk story or potential. They're all hidden assets, cash flows, and valuation.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. I mean, you can make money on a fallen angel like Merck (NYSE: MRK  ) , but its triples and quadruples are mostly in the past. Same goes for well-understood megacap techs like Qualcomm (Nasdaq: QCOM  ) and Motorola (NYSE: MOT  ) .

They're decent companies. They're just too big. But what if we took the old-school valuation techniques made famous by Ben Graham and Warren Buffett, and applied them to up-and-coming smaller companies whose growth spurts are still ahead of them? Again, I know it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget "the next home run stock"
If you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with people like Chuck Royce and David Nierenberg (whom we had the pleasure of meeting here at Fool HQ a while back), the team Tom assembled to manage his Motley Fool Hidden Gems service are among the few folks I've seen cash in on this little "trick."

The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals selling at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing the fun stuff -- "story" and "potential" -- with old-fashioned fundamentals and valuation.

Tom never tires of explaining that this is precisely what led investors to Wal-Mart in the '70s. Or that they turned a $5,000 investment into $2.5 million. But what was so great about Sam Walton's general store back in 1975? A few things.

Follow the money
For starters, Wal-Mart was rapidly expanding revenue and profits, even back in 1975. That's clearly not the case with too many of today's hot story stocks -- not to say they don't have potential, of course.

Unfortunately, they're all "potential." Speculating on companies like these may work out for you, but it may not. Either way, it's a wild ride. As a long-term holder of Echelon (Nasdaq: ELON  ) and ImClone -- recently sold to Lilly (NYSE: LLY  ) -- I can testify to that.

Don't assume you should never take a flier; just know that balance is key. The safer play, obviously, is to dig up small caps like Wal-Mart when they're still small but making money, and let them methodically generate a pile of cash for you over the years.

After all, this "trick" turned $1,000 into $33 million
Granted, it took nearly 70 years to do it, but according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large caps instead. Will those numbers hold up? Well, the analyst team has been mining small-cap value at Hidden Gems for just a couple of years now, but judge for yourself.

So far, they have alerted their subscribers to literally dozens of small-cap value stocks. Seven subsequently doubled or more, and as of this morning, the entire portfolio is beating the broader market by eight full percentage points.

How about some really good news?
You don't have to pay Harvard to find great small-cap values anymore. You can pick up Ben Graham's Security Analysis on Amazon. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- with no heavy reading or speculation required.

You can join sample Hidden Gems free for 30 days. Check out the complete Hidden Gems service for a full month, including all past and current recommendations, every newsletter issue and special report ever published. Then take a whole month to decide whether you want to sign up.

I guarantee that you'll meet lots of friendly and knowledgeable folks, and nobody will pressure you to subscribe. Best of all, the first lesson ... and the team's top five picks for new money right now ... is on me. To take advantage of this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on the progress at Hidden Gems (yes, through good times and bad). You can view all Hidden Gems picks immediately on the official scorecard with your free trial. Paul owns shares of Echelon. Lilly is an Income Investor recommendation. Intel and Wal-Mart are Motley Fool Inside Value recommendations. The Motley Fool has a disclosure policy.


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