Blame It on the Rain

The stock market is not without its tough days/weeks/months/years, and October has been a tough month thus far. The S&P 500 has shed more than 4% since the beginning of the month. These difficulties have been amplified for small caps: The S&P SmallCap 600 is off more than 6%.

Some of this short-term pain is warranted. Recent hurricanes caused gas prices to spike and made the looming threat of an expensive winter all the more real. Moreover, short-term interest rates are rising and the threat of a catastrophic terrorist event still exits.

Small caps take it on the chin
Frankly, it's not a great time to be running a business. A lot of the same costs that hit the consumer in the pocket also hit the bank books of every entrepreneur, from the mom-and-pop business owner to the international tycoon.

Take the recent hurricanes, for example, which substantially disrupted a number of major sectors of our economy, including energy and manufacturing. Clorox (NYSE:CLX) -- a relatively staid consumer products company with impressive 15.6% 15-year compound annual growth -- announced on Oct. 4 that it was lowering earnings guidance for the second quarter and the full fiscal year, citing rising raw materials and manufacturing costs.

Yet the market barely responded. That's the benefit of owning shares in an $8 billion company that pays a steady 2% dividend, has a stable of strong brands, and can raise prices in an inflationary environment.

Some of the small caps in the Motley Fool Hidden Gems portfolio haven't been so lucky. Stanley Furniture, which is all of $300 million, has slumped more than 20% this month after missing earnings estimates on Oct. 17 and lowering guidance for the rest of the year. The cause of this hardship is, in part, rising raw materials costs (including an industrywide foam shortage).

According to La-Z-Boy (NYSE:LZB), which announced that it will "significantly miss earnings estimates" as a result of this shortage, foam is shipped only when needed because of the large amount of storage space it consumes. As a result, any supply-chain disruption can prevent firms from meeting market demand or force them to pay significantly higher raw materials cost. La-Z-Boy was down 8% on the news, and the stock has continued trending down after lowering its guidance on Oct. 17.

Still, it's the small cap that suffered more.

The throes small-cap volatility
There are a number of sound reasons why small caps tend to have more amplified swings than their larger market counterparts. For one, trading volumes are lower. This means that each buy or sell order has more of an effect on a stock's price. Second, small caps tend to be lesser-known entities. This means that investors, for good reason or not, are more wont to jump ship at the slightest hint of bad news. If a company like 3M (NYSE:MMM) -- with a greater than $50 billion market cap, a track record of innovation, and more than 100 years of history -- can drop more than 10% on news that its CEO is departing, just imagine the kind of effect that similar news could have on a small cap.

Or don't. GreenfieldOnline (NASDAQ:SRVY) -- a $150 million company -- dropped 22% on recent news that its CEO was resigning. (To be fair, the company also lowered guidance.) But that's another risk of small-cap investing: bad news tends to snowball. Unlike larger companies, small caps don't have the same cash hoard or diverse revenue streams. Sometimes, small caps don't have the experience to survive a rough patch and emerge stronger.

Be one with the small cap
Yet small caps offer nearly unmatched growth potential for a very simple and obvious reason: they're small. Over the past 10 years, the S&P SmallCap 600 has outpaced the larger S&P 500 by nearly four percentage points per year (11.1% vs. 7.4%). That's a fairly substantial difference. While a $10,000 investment in the S&P 500 would have appreciated to just over $20,000, the same investment in the SmallCap 600 would be worth $28,651.

And there's hope of doing even better than that. The key to small-cap investing is careful selection. Because they are largely underfollowed by both the media and institutional investors, small caps give individual investors the opportunity to slip in early in a company's lifecycle and separate an Apple (NASDAQ:AAPL) from a Commodore. You can't even try to do the same today with a heavily followed and actively traded stock like Oracle (NASDAQ:ORCL).

There are a number of ways to identify promising small caps, but Motley Fool co-founder Tom Gardner and analyst Bill Mann have distilled a six-point list that they use in their Motley Fool Hidden Gems small-cap newsletter service. Those six criteria are:

1. Founders with large personal stakes.
2. Financial statements that are easy to understand.
3. Lots of cash and little or no debt.
4. Price ratios that undervalue free cash flow growth.
5. Dominant positioning in a profitable niche.
6. Market growth opportunities.

The two common factors in all these traits are integrity and flexibility. Although integrity and flexibility are not as technical as moving averages or as impressive as inventory divergence, they are the keys to finding small caps that will enrich you for decades.

Why? Because no small company can avoid a rough patch every now and again. But small companies that have dedicated management, stable business models, and ample cash are more likely to weather a storm, whether it be rising energy costs, foam shortages, or a plain old rainy day.

And although Tom and Bill have used those criteria to build a collection of small caps that have bested the S&P 500's total return by nearly 20 percentage points since the newsletter's inception, it doesn't mean that the companies they find are immune to the market's intense swings. Hidden Gems recommendation Montpelier Re was hammered to the tune of 20% on the news that it had hurricane exposure somewhere in the neighborhood of $500 million. That was significant for a company capitalized at $1.5 billion and holding only $110 million in cash on the balance sheet. In the end, Montpelier was forced to sell an additional 25 million shares of stock to the public.

Compare that situation with Allstate (NYSE:ALL), a much larger company that shed only 8% of its value despite total industry losses estimated to be north of $30 billion. Sometimes it's tough to hold small caps.

Yet Bill remains confident that in this now-hardened market, Montpelier will continue to be a compelling opportunity for long-term investors. To take a look at the nearly 50 other active recommendations, consider a 30-day free trial to the newsletter. Although today's conditions can be harrowing for small-cap investors, a collection of superior companies can help you achieve the compelling long-term rewards that only small caps can offer.

Tim Hanson owns shares of 3M, which is a Motley Fool Inside Value recommendation. La-Z-Boy is a Motley Fool Income Investor recommendation.At the Fool, no writer is too cool for disclosure ... and Tim's pretty darn cool.