It's been more than two years since I woke up from my investing hangover. Listening to too many Wall Street gurus, I was in and out of stocks, trying to predict the short-term future while almost ignoring the long-term picture altogether. Investing is about building long-term wealth, and I didn't quite grasp the power of a buy-and-hold philosophy.
I've since taken back my financial future from the Wall Street "pros," and I now have a set list of what to look for in any potential small-cap investment. If my hard-earned dollars are going toward an investment, it must have:
- A sustainable business, with plenty of room to grow.
- Dominant positioning in a profitable niche.
- Founders with large personal stakes in the future of the company.
- Sturdy balance sheets, featuring a solid asset base with little or no debt and rising free cash flow (FCF).
- Price ratios that significantly underestimate FCF growth rates.
- Financial statements that are easy to read -- because that indicates straightforward management.
- Stocks that have little institutional ownership and are largely undiscovered by mutual fund managers and Wall Street.
That's how I find small-cap stocks. Using the above criteria, I've got my eye on a few possible investment candidates, including Aeropostale (NYSE:ARO), Martha Stewart Living (NYSE:MSO), and Quality Systems (NASDAQ:QSII). But how can you go about maximizing your gains from the great stocks you've already found? Take it from me (and I'm speaking from painful personal experience): The only way to maximize gains is to be patient.
The virtue of patience
I approach a potential investment with at least a three- to five-year time horizon. This is particularly important for small caps because they tend to be more volatile than the overall market. But even when one abruptly drops, I comfort myself with the old market adage: More risk means more reward, as long as the original thesis for my investment remains intact.
So here's what I don't do with small caps:
- Play short-term volatility by riding rises, selling, and buying back after drops.
- Sell covered call options to juice returns on stocks that just "sit there."
- Automatically dump small caps at the slightest hint of trouble.
The common theme running through all of these old habits of mine is impatience -- with a side order of cockiness. The old me wasn't willing to wait for market-beating returns -- I was going to make them happen! Unfortunately, the market eventually buries the impatient and the cocky like me ...
Don't time the market
I purchased Overstock.com (NASDAQ:OSTK) on four occasions between August 2003 and October 2003 at a weighted average price of $14.14. I sold all of my positions on Jan. 12, 2004, for $16.50 per share -- thinking I had timed a temporary upswing and could get back in later. Yeah, later. Overstock now trades for more than $45 per share after trading as high as $75 -- although I would've held even at that price. I like Overstock.com's long-term prospects, but my impatience cost me a double.
I picked up shares of oven maker (and Motley Fool Hidden Gems recommendation) Middleby before it was a market-beating monster. Around July 2004, I got worried about the general direction of the market, so I decided to take some gains on Middleby, wait for the market to drop, and then jump back in. I sold part of my position for $53.78 per share. After being shredded by a short-term capital gains tax (approximately 42%, after the various levels of government took their cut), I realized a $20-per-share gain. And that was great -- until, that is, the market never dropped and Middleby kept rising to almost $70 per share today. Yep, that's a triple I missed by trying to time the market.
Don't play with covered calls
Covered calls seemed like such a simple way to make money. I mean, why not get paid to wait on a stock that was fundamentally sound but seemed to be going nowhere? I decided to test my theory on Valero (NYSE:VLO) -- back before it was the top-performing stock in the S&P 500. I purchased Valero in August 2003 for a split-adjusted $19.90. The stock had been essentially flat for months, so in November I sold June 2004 covered calls at $22 -- for just $1.20. Easy money, right? Well, by the time the calls were exercised in June 2004, Valero traded for more than $30, and I lost shares that now trade for nearly $90. That impatience cost me a four-bagger.
Don't abandon ship
CNS (NASDAQ:CNXS) is a Hidden Gems recommendation that I purchased four times between August 2003 and January 2004 at a weighted average cost of $12.07 per share. After a substandard quarter, the impatient me sold away the stake for a mere $9.95. CNX now trades for almost $30 per stub and is on a steady upward slope. Impatience cost me another triple.
Foolish final thoughts
Since I don't want you to think that everything I've done is stupid, I did keep the bulk of my Middleby and added to that position when shares temporarily dipped in the high $40s. Gone are the days when I dreaded small-cap volatility; now I embrace it. My newfound patience handsomely rewarded me there.
Maybe next time I'll talk more about the "rewards of patience" -- I've got some great stories on that topic as well. But the key to being patient is finding great stocks that I'm comfortable waiting out. Those seven criteria above aren't my own; they come from Tom Gardner, co-founder of the Fool and lead analyst of Hidden Gems. Since inception, his newsletter is beating the market by more than 20 percentage points, and it's helping every subscriber find great stocks and learn to be patient. It's simply the best investment information resource I've come across in my 58 years of looking.
Tom Gardner is offering a free 30-day trial to his market-beating Hidden Gems newsletter service. To take him up on the offer, simply click here.
Ted Murphy is a dropout from more than 25 years of corporate wars and is now a semi-retired beach-bar and restaurant entrepreneur. What he doesn't know about investing, he is patiently trying to learn. Of the stocks mentioned in this article, he owns shares of Middleby and Quality Systems. Quality Systems is a Motley Fool Stock Advisor recommendation. Overstock.com is a Motley Fool Rule Breakers recommendation. The Motley Fool has a disclosure policy.
