The Next Home Run Stock

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

I assume that you, like everyone and his Aunt Avis, would love to find the next Wal-Mart -- to dig out the market's most precious Hidden Gems. Back in November 1980, Wal-Mart traded at a split-adjusted price of $0.01 per share. Today, it trades at $53. Wal-Mart has risen 5,300 times in value over the past quarter-century, turning a $5,000 investment into more than $26 million.

Of course, you'd love to buy the next Wal-Mart.

But you'd prefer not to take on extreme 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've all searched 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.

Forever great
But remember, companies like Wal-Mart typically exhibit excellent financials from the day they hit the public markets. Wal-Mart was never a penny stock (again, that share price of $0.01 back in November 1980 is split-adjusted; the stock traded at $50 back then). Wal-Mart didn't hype itself in press releases, nor did management make outlandish promises to its investors. It turns out that if you want to find monster long-term winners, you shouldn't throw money at shaky, speculative companies.

Wal-Mart founder Sam Walton, who owned a massive stake in the enterprise, ran his company conservatively for decades. And just four years after its IPO, as a tiny public company, it began paying a dividend. This is a business that was run to sustain yearly profit growth indefinitely. If you're going to invest in small-cap rocket stocks, as we do together in Hidden Gems, please avoid the whisper-stock party tips and hype jobs. They destroy wealth over time. Wal-Mart wasn't getting hyped. No one was following it!

And so, contrary to popular perception, you need not assume great risk to invest in the best small caps. You need only to train yourself to look for disciplined, conservatively run small businesses.

And finding these hidden gems doesn't involve a hopeless search through barn-sized haystacks for a lone platinum needle. The stock market features plenty of promising smaller companies run successfully by founders with large personal stakes in the enterprise. In fact, hidden gems thrive in every industry -- technology, finance, leisure, medicine, retail, and beyond. Take a look at these five great investments from 1990 to 2004, all of which were small caps in the early '90s.

Note, again, that this group hails from a broad variety of sectors. Some are familiar consumer brands, while others -- EMC, for example -- are to this day largely unknown on Main Street. But each was a small cap fourteen years ago. And not only weren't they industry stalwarts, but they were also largely unknown to consumers and investors. They had yet to attract a cadre of Wall Street analysts and big institutional investors.

And their stock prices reflected it; they were cheap because they were irrelevant!

They're what we search for together, every day, in Hidden Gems.

And these sorts of opportunities do exist today. Witness the tenfold rise in the value of online closeout retailer Overstock.com (NASDAQ:OSTK) since October 2002.

The next big thing
The 20- 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 Intel. And they aren't Merck or IBM or General Electric (NYSE:GE). They're not companies valued in excess of $100 billion, covered by 39 Wall Street analysts.

They're small companies with strong founders and executive ownership north of 15%. Companies without debt concerns. Companies that generate excess cash from their operations, some of which already pay dividends. 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 see that many of these small businesses offer low risk and high rewards for their long-term owners. How could a small company be less risky than a giant is? Ask the former owners of WorldCom. Not only was that company overfollowed; it was fraudulently run!

The exact opposite exists with great small-caps. They're well-run and underfollowed on Wall Street, creating price inefficiencies that strongly favor long-term investors.

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

What I look for
Every day in Hidden Gems, we track down the following:

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-cap stock is doomed to have a larger competitor stomp it out, I ask you to return to my list of strong performers above. Each rose up from obscurity because of sound financial management and shareholder-friendly practices. The free markets gave them plenty of maneuvering room.

But because not every small company is poised for enduring success, I evaluate more than 100 of the 3,000-plus small-cap stocks each month -- all in search of one great Hidden Gems recommendation. As for the others, I find that 90% are too richly valued or too speculative, given the underlying business. That remaining 10%, however, leaves us with hundreds of small caps that will beat the market and dozens that will rise more than 30 times in value over the next 10-15 years.

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

Tom Gardner is co-founder of The Motley Fool, which consists of investors writing for investors. He does not own shares in any of the companies mentioned.