Wall Street's Worst-Kept Secret

By Paul Elliott | More Articles
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Hey buddy, want some personal investment advice?

If you own stocks, you should own some small caps. Of course, there's nothing personal about that. It's Wall Street's worst-kept secret.

You're serious about this
You want an edge. So why make this tricky? Everybody knows that investors who make the most money over the long term buy common stocks.

At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who make even more buy small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). Or we can get to work building a 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've been at this for a few years, but I also down the occasional cup of joe with Tom Gardner. Tom has made a career out of beating Wall Street to well-run small companies.

And you know what? I'm man enough to admit that the team Tom hand-picked to run his Motley Fool Hidden Gems investment advisory service has assembled a portfolio of small caps I probably wouldn't have found on my own. What's their secret? I think it's that they focus on value, while I love a good story.

Yet for all our differences, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. Smart investors have always looked for:

1. Solid management with significant stakes.
2. Great, sustainable businesses.
3. Dominant positions in niche markets.
4. Sterling balance sheets.
5. Strong free cash flow.  

I know it's hard to imagine, but these traits gave investors the courage to follow young Scott McNealy into Sun Microsystems (Nasdaq: JAVA  ) , Michael Dell into Dell Computer (Nasdaq: DELL  ) , and even Andy Grove into Intel (Nasdaq: INTC  ) . All were fantastic investments when I was coming up.

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those now -- if they're really all that, they're going to cost you.

So what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference.

For example, big retailers like TJX (NYSE: TJX  ) -- the folks responsible for TJMaxx stores -- are widely owned now, but I remember when the stock was underfollowed on Wall Street (and I'm not that old).

Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. Just don't expect to find General Electric (NYSE: GE  ) or Pfizer (NYSE: PFE  ) on the list, or any other of yesterday's must-owns.

In fact, I'm willing to bet Apple (Nasdaq: AAPL  ) is the only one you've ever heard about from your broker. Yet, over the past 10 years, this handful of relative unknowns earned investors anywhere from 2,900% to 21,000%.

You see, there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these hidden gems, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% year after year.

How to get rolling
Way back in September 2003, I suggested you take a look at a pair of small-cap ETFs. I'd bought the iShares S&P 600 Growth Index (IJT) at about $65 earlier in the year and was pleased with my returns.

I pledged to buy the sister fund, iShares S&P 600 Value Index (IJS). Even after one of the swiftest market sell-offs I can remember, the growth fund is still up roughly 20% since. The value fund has done nearly as well -- again, despite the recent pullback (read: opportunity).

More important, these funds trade just like stocks, allowing you to quickly take advantage of what my favorite money manager Marty Whitman calls, "the opportunity of a lifetime," without having to take the plunge on the stocks of individual companies.

Or how about this?
A lot of folks are testing the waters with low-cost funds like these, and then shifting gradually into the stocks you can hear about each month in his Hidden Gems newsletter. After all, sooner or later, you probably want to take advantage of at least a few small businesses with big potential.

That's the way to beat the market. Meanwhile, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of just recently, the recommendations have dipped into the red, down on average 17%. As discouraging as that sounds, it's considerably better than the S&P 500's decline of 28%.

Especially if you agree with me (and Marty Whitman and Warren Buffett) that this market is the buying opportunity of a lifetime.

If you have the nerve, and if you want to learn more about how to put Wall Street's worst-kept secret to work for you, consider taking a free trial to the complete Hidden Gems service. You don't have to join, and you can sneak a peek at every recommendation and print out the entire archive of newsletter issues.

There's no pressure to join. To learn more, 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. Apple is a Stock Advisor recommendation. Intel, Dell, and Pfizer are Inside Value picks. Pfizer is also an Income Investor selection and a Motley Fool holding. The Motley Fool has a full disclosure policy.