"A computer on every desk and in every home running Microsoft software." -- Bill Gates
And thus it began. For Microsoft
Like many of its own investors, Microsoft was once a small-timer with big dreams. But Bill's famously visionary quote provides an uncanny sense of the managerial vision -- not to mention clarity -- that later propelled his company from the ranks of the also-rans.
Unfortunately, "also-rans" pretty much describes most investors. Lacking a clear approach, they chase after certain stocks, typically famous ones -- and usually after they've already had their run -- and too often wind up with disappointing gains. That's why, in getting to the three stock picks, I'll walk you through the basics of an investing philosophy we use a lot here at the Fool. A stock pick alone isn't worth half as much as the logic behind it, in our opinion.
My friends and family already know this, but I'll declare it publicly now: My next computer is going to be a Mac
But for investors looking for lessons, pegging brilliant yet unproven management is a tough thing. Fortunately, and if I may quote Tony Robbins, "Success leaves clues," i.e., other clues.
Take eBay
But the company had a vice, at least as an investment. Sure, it is, and was, a great business. But the world was watching -- and betting on -- its every move from shortly after its IPO. Reality check: Despite some ups and downs a few years ago, eBay has been a great investment. My point is simply that had it not been so high-profile early on, it could have been a mind-blowing investment. Stocks that go big-time in no time don't leave much of a window for investors to jump in.
That's why I, along with many of us here at The Motley Fool, am a fan of small-cap investing. We like to buy stocks that don't attract a lot of fanfare and analyst attention, or at least won't for a while. That might mean passing on "known" winners (a la Smarty Jones before the Belmont Stakes), but by making our decisions in calmer waters, we believe we're getting a better view of the horizon.
Boring stocks = few speculators
Portfolio Recovery Associates
Like all of our Hidden Gems picks, we're thinking three-year time frame, minimum. And we believe Portfolio Recovery has what it takes -- in this case, an analyst-projected 19% five-year earnings growth rate. That's no 1980s Microsoft or 1990s Dell
Sure, we'll jump on a potential highflier if we see it. And we're not averse to middle-of-the-road-excitement companies either. That flexibility is part of what makes Hidden Gems investing tick -- and by tick, I'm talking about total returns of 22.6% since we started the newsletter in July 2003. That's compared to 4.5% for the S&P 500.
That flexibility, however, can exist because many other criteria have been cast in stone. Criteria gleaned through investing lessons learned the hard way -- from past experience -- and by modeling prior successes. Lessons validated and supplemented by many of the greatest investing minds -- such minds as Buffett, Graham, and Lynch. And we're putting them to practice evaluating thousands of small caps every year.
No stock is perfect. The 22.6% Hidden Gems returns include several investments that have lost money to date. We believe some are in the red temporarily; since we don't try to guess the near future, we're not as worried about those. But we pegged one former recommendation, Talk America, as being down for the count, about which we notified our newsletter subscribers once we made the decision.
The market is riddled with uncertainty. It's that very uncertainty, though, that opens the door to the possibility for big returns. If everyone knew at the IPO that Dell would rise to such dominance in the PC business, the stock would have quickly risen to reflect that certainty.
Guessing the magnitude of large-scale trends is a tough business, and we don't pretend to be experts at it. Fortunately, besides a willingness to explore less flashy but cheaper businesses, we're aided by some specifics that future winners tend to have in their early stages:
- Strong products or services with the opportunity to grow
- Insiders/founders unafraid to hold large stakes
- Institutions unable to hold large stakes
- Sparse analyst coverage on Wall Street
- Not bogged down by debt
- Solid returns on assets, on equity, and on capital invested
- Valuations that suggest the high-expectations (read: bubble) crowd isn't interested
Three to watch
I can't spill the beans on the current Hidden Gems recommendations (though you can see what they are by signing up for a free trial), but I'll pluck a few names off some recent Watch Lists -- a feature in the newsletter where we list stocks we're sizing up but haven't taken the plunge with -- to give you an idea of the variety of ideas we present. Some have bumped up a bit since they appeared on the list, but they should still have room to grow within that three- to five-year (minimum) time frame we like to consider when making investments.
Ventiv Health
Natus Medical
ScanSource
Want more on Hidden Gems? Here's how it works: Every month, you'll get our two best small-cap stock picks -- one from Tom Gardner, another from a guest analyst. Plus, you'll get stocks on Rex Moore's very successful Foolish 8 screen, along with full access to an online community of other subscribers. Afree trialis yours for the asking.
James Early owns none of the stocks mentioned in this article. The Motley Fool has a disclosure policy.
