If you invest in stocks for the long term, you must own small caps.
There, I said it. But come to think of it, that's not personal investment advice at all. That's Wall Street's worst-kept secret: Over the long haul, smaller-company stocks outperform their mid- and large-cap peers, so the most successful long-term investors own them. Period.
Only what you need
I'll back that up with some hard data, but first, let's talk about you. You are serious about this stuff; otherwise, you wouldn't still be reading. You also want an edge -- a secret -- that will help you do better over the long haul than the average investing Joe. We all want that edge.
So why make this harder than it needs to be? Investors who make the most over the long term hold diversified portfolios of common stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. Stock investors who make even more hold small caps -- at least they have so far, also according to Ibbotson.
Sticking with our "simple" theme, here's how I see it. You can buy a small-cap fund that keeps its costs in check, though the good ones are as hard to get into as a decent preschool. You can ...
- Buy one of a growing number of great small-cap exchange-traded funds (ETFs).
- Take your chances on a small-cap mutual fund that's open for business.
- Seek out -- with or without the help of a trusted advisor -- the very best smaller companies, and build a small-cap portfolio of your own.
You're a Fool ...
... and so am I. So you'd think we'd favor the do-it-yourself approach. Well, sort of. I've been around, and I own my share of small caps. But I also have the occasional cup of joe with Motley Fool co-founder Tom Gardner, who digs up well-run small companies for subscribers to his Motley Fool Hidden Gems advisory service -- and he never shuts up about it.
So I think about this a lot. And you know what? For better or for worse, Tom's more disciplined, more strict value approach has resulted in a portfolio of small-cap gems I wouldn't have built on my own. One that -- gun to my head, and assuming I'm in it for the long term -- I would swap straight up for mine. There, I said it again.
For all that, Tom and I look for many of the same things in a great small company. It's what many of the all-time great value investors have always sought. For more on this, check out my mild rant, "How to Beat a Choppy Market." But here's the short list for now:
- Solid management with significant stakes
- Great, sustainable businesses
- Dominant positions in niche markets
- Sterling balance sheets
- Strong free cash flow
Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? And you're right. That's why it's so hard to outmaneuver the pros with titans such as Wal-Mart (NYSE:WMT) and Intel (NASDAQ:INTC) -- they're both great, but they're going to cost you. How much? An efficient market theorist would say just enough. I'd argue it's too much.
So what can you do? Take a chance on some fly-by-night outfit? Good point. But note that I said well-known stocks -- not companies. There's a difference. eBay (NASDAQ:EBAY) and, more recently, JetBlue (NASDAQ:JBLU) both turned out to be nice investments, but both were stocks almost before they were companies.
Contrast that to an outfit like Southwest Airlines (NYSE:LUV). Or even TJX, which runs a discount store on every corner. (TJX stock, incidentally, has risen by about 1,000% in 10 years). Both hit Wall Street's radar ... eventually, but they were well known on Main Street years before. More importantly for us, there is always a new crop of established, profitable companies with lesser-known stocks.
Some of these you will have heard of, and some you may not have -- yet. Some even dominate their markets. Peter Lynch was a master at finding these stealth bombers, and he earned his Fidelity Magellan fundholders nearly 30% per year as a result. With a little work, we can do it, too.
Here's how I know
I stumbled upon Harley-Davidson the stock after having seen (and heard!) the bikes for years. I saw for myself -- in a hospital, of all places -- how an upstart medical device maker called Medtronic (NYSE:MDT) wrestled Goliath Johnson & Johnson (NYSE:JNJ) for a share of a $25 billion market. (It's Medtronic, not surprisingly, that is up some 700% since 1995.)
There are exceptions, but it can take a long time for a stock to cross the big boys' radar, even if they use and swear by the company's products themselves. And when it does, it usually hogs the radar screen long after it should have blipped off. That gives us a great advantage as individual investors. The trick is to find these stocks and buy them before the big money drives them to the stratosphere.
Take your time
Back in September 2003, I suggested you get the ball rolling with a hard look at a pair of small-cap ETFs. I'd bought the iShares S&P 600 Growth Index (IJT) myself at about $65 earlier in the year and was thrilled with my returns. I pledged to buy the sister fund, iShares S&P 600 Value Index (IJS), next -- a promise I thankfully kept.
I don't bring this up now to brag, but to make two points: First, all who said that the small-cap rally was over back in September 2003 were wrong. (My hunch is that there are even more saying it after the latest small-cap pullback -- and that they're still wrong.)
More importantly, these funds, which trade like stocks, offer you quick and dirty small-cap exposure without the risk -- perceived or otherwise -- of taking the plunge on the stocks of individual companies. The strategy of holding the funds, and then shifting into Tom Gardner's Hidden Gems after digging at your leisure, strikes me as sound. As does simply holding the funds as a means of diversifying one's small-cap exposure.
Buy the numbers
Earlier, I promised you numbers. Ibbotson Associates is the undisputed king of market data. According to Ibbotson, small-cap stocks have delivered annual returns of 12.4% since 1926. That's compared with 10.7% for large caps. Put another way, $5,000 invested in small-cap stocks and left to sit would grow into about $52,000 over 20 years. Imagine if you'd been adding to your position. Nice.
And that's overall. In periods when small caps do outperform, they seriously outperform, and they tend to do so for periods lasting -- depending on whom you ask -- from five to seven to 10 years or more. Frankly, I don't think the small-cap run is over. Either way, it's axiomatic: Today's giants sprouted from well-run small companies, taking smart investors along for a swell ride. So will tomorrow's.
What to do now
In my last column, I promised to keep you posted on Hidden Gems' performance. As of July 6, 2005, the recommendations were up, on average, 33.9%. That's compared with just 7.6% if you'd invested in the S&P 500 for the same period. For context, that's about 50 picks over more than two years -- and, I confess, it's better than I have done myself.
To learn more about Tom Gardner's approach to beating the market with small-cap value, Tom is offering a free trial to his Motley Fool Hidden Gems advisory service. You can take it up directly with him and sneak a peek at all his back issues. Simply click here to try it out for 30 days.
This article was originally published on Jan. 7, 2005. It has been updated.
Fool writer Paul Elliott owns none of the stocks mentioned. eBay and JetBlue are Motley Fool Stock Advisor recommendations. The Motley Fool has a fulldisclosure policy.
