Home Run Stock Redux

This article was first published on Sept. 24, 2003. It has been updated.

I am certain that you, like everyone and their Aunt Avis, would still love to find the next Microsoft (NASDAQ:MSFT). We'd all love to dig up the market's next Hidden Gems. Back in January 1990, Microsoft traded at a split-adjusted $0.62 per share. Today, even after pulling back dramatically since January 2000, the stock is up around $25. That's an increase of 40 times for long-term investors. Put another way, $5,000 invested in Microsoft in 1990 is worth roughly $200,000 today.

Of course, you'd love to buy the next Microsoft.

But you wouldn't want to take on extraordinary risk, right?

I think you're smart to think that way. And so does a long list of great money managers -- from Peter Lynch to Seth Klarman, Jean-Marie Eveillard to Charles Royce. They all search for small companies with a mixture of sales and free cash flow growth, superior returns on invested capital, heavy insider ownership, and healthy assets -- all at a reasonable price.

Born to be the best
But remember, companies like Microsoft typically display excellent financials from the day they hit the markets. Microsoft was never a penny stock (again, that 62 cents in January 1990 is adjusted for numerous splits along the way). It didn't hype itself in press releases, nor did management make outlandish promises to investors.

Companies like Microsoft are run conservatively by executives who themselves own large positions. They're run to sustain profit growth indefinitely. That's in contrast to the whisper-stock party tips that destroy wealth over time.

Contrary to popular perception, to invest in the best small caps, you need not assume substantial risk.

And finding these hidden gems doesn't involve some desperate dig through barn-sized haystacks in search of the elusive platinum needle. The public markets feature plenty of promising smaller companies run successfully by founders with large personal stakes in the business. In fact, hidden gems thrive in every industry -- technology, finance, leisure, medicine, retail, and beyond. Take a look at these seven great investments from 1990-2003.

Note first that this group reflects a broad variety of sectors. Some are familiar consumer brands while others -- for example, Medtronic and Applied Materials -- are to this day largely unknown on Main Street. But each was a small cap back in 1990. Not only weren't they industry stalwarts, they were largely unknown to consumers and investors. Companies like Charles Schwab and Dell and Lowe's -- household names today -- had yet to attract Wall Street analysts and big institutional investors.

And their stock prices reflected that. These sorts of opportunities exist today.

The next big thing
The 20-baggers to 700-baggers of the next 15 years are out there right now, with their fuses lit and a wide-open sky above them. But they aren't Charles Schwab. And they aren't Amgen. And they aren't Microsoft. They're companies not yet covered by 39 analysts.

They are companies with founding leadership, or at least insider ownership north of 15%. Companies without debt concerns. Companies that generate excess cash from their operations. Companies that function without any real reliance on Wall Street for financing or table-pounding "Strong Buy" ratings.

I know it sounds contrary, but I want you to consider the fact that many of these small businesses offer rewards that substantially exceed the risks of owning them. How could a small company be less risky than a larger one? Well, the mere fact that even the best-run small companies are underfollowed on Wall Street creates pricing inefficiencies that strongly favor long-term investors.

Does that sound possible? Does it sound logical? It's certainly contrary.

The small-cap risk myth
We're accustomed to thinking that small-cap stocks must be speculations. They must be riskier than big, friendly corporate names that have always seemed to be there for us. But are they? In the best small-capitalization stocks, you'll find the following features that mitigate the risk of owning them:

1. Founders with large personal stakes
2. Financial statements that are easy to read
3. A solid asset base with little or no debt
4. Price ratios that significantly undershoot growth rates of free cash flow
5. Dominant positioning in a profitable niche
6. Plenty of room to grow

If you're inclined to think that every small-capitalization stock is doomed to get stomped out by a larger competitor, I ask you to return to my list above. They all rose up from obscurity through sound financial management and shareholder-friendly practices. The free markets provided them plenty of maneuvering room.

And the free markets today provide plenty of competitive space for small companies led by numbers-driven founders whose wealth will grow over the next 15 years based principally on the performance of their stock.

But because not every small company is poised for enduring success, I evaluate more than 100 of the 3,000-plus small-cap stocks -- all in search of one great Hidden Gems recommendation each month. As for the others, I find that 90% are too richly valued or too speculative given the underlying business. But that remaining 10% leaves us with hundreds of small caps that will beat the market, and dozens that will rise more than 20 times in value over the next 15 years.

You can read about this, and all my Hidden Gems recommendations, by signing up for a 30-day free trial here. There is no obligation to subscribe. You have my word.

Tom Gardner is co-founder of The Motley Fool, which is investors writing for investors.