You know who you are. I've been knocking around this business for years, and everywhere I've stopped, I've met you. And every time I turn up someplace new, I take one or two of you along with me.
Behold! My own personal whisper-stock-party-tip rumor mill. One day, it's a call from Mark in Rockville. Then it's Sean from Miami or Shannon from Boston. And just when you think you've heard it all, it's the other Mark from New York. He's the worst of the lot.
The greatest stocks of all
A while back, I argued that Wall Street's worst-kept secret is that small-cap stocks outperform their larger-cap peers over time -- and that successful stock investors own them. What, then, is Wall Street's best-kept secret?
I'll spare you the drumroll. It's that micro caps do even better. At least a certain type of them do. In a bit, I'll back that up with numbers. Heck, I'll even toss in a few anecdotes, but first, some fine print.
Micro caps are not for everyone. They're for people like Sean and Shannon and the Marks. They're for people who love this stuff -- who have the inclination to do some real digging. Or have someone they trust to do it for them. (More on that in a bit.)
Do you love this stuff?
No offense to my rumor mill, but you know it's hard to find detailed -- dare I say trustworthy -- research on tiny companies. Not even the boutique shops offer much by way of coverage. And you can pretty much forget about Wall Street. Believe me, I've looked.
So we're left with the rumor mill. And to be fair, we've done all right over the years. The rumor mill found Pulte, which I bought and dumped for a 50% profit. (Big mistake -- even after a pullback it's still up some 700% since.) We locked onto JDS Uniphase (NASDAQ:JDSU), which I neither bought on the way up nor sold on the way down. (Two big mistakes.)
Best of all, we had a whole lot of fun. But, in a sense, we were just winging it. Our method was never rigorous, and to this day the rumor mill deals in high hopes and speculations.
But tiny doesn't
have
to mean risky
What if I told you that Wal-Mart (NYSE:WMT) once boasted a market cap of less than $30 million? Yet even then, the company made money. It was shareholder-friendly, conservatively managed, and owned by obsessive founders. But Wall Street's investment banks had little use for it. Too bad.
Had you invested $5,000 back in 1980, you'd be sitting on about $2.5 million today. Hindsight is 20/20, and Wal-Mart is an extreme example, but it hardly seems that Wal-Mart was ever a particularly risky investment. After all, it actually paid a dividend, even when it was a small fry.
What you want, obviously, is to find companies today with the characteristics of a 1980s-era Wal-Mart. As with any small cap, insist on these in any micro cap:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
Just insist twice as hard. Because the smaller the company, the more important these things are. Best case, look for a micro cap that pays a dividend, like Wal-Mart did. A dividend implies a lot of good things, including that the company won't be out begging for new capital -- a great sign if ever there was one.
Many fish in the sea
Think you could never have found Wal-Mart? Maybe, but how about Ameritrade (NASDAQ:AMTD) or Home Depot (NYSE:HD)? Both were right under our noses, and both made fortunes for early investors. If you're a mall rat, you could have bought American Eagle Outfitters -- an original rumor-mill find -- as recently as 1997 for a 5,000% gain.
That's the beauty of getting in early. The rise and fall of Cisco (NASDAQ:CSCO) and friends is the stuff of legends. Investors who bought in 2000 have been sorely disappointed. Those who bought tech stocks back in 1990 are still sitting on obscene profits. And then there is Dell (NASDAQ:DELL). Had you bought Dell in 1990, you'd be up some 40,000%.
But here's the real beauty of getting in early: Those first few doubles and triples matter. If you'd waited on Dell just until January 1992, you'd still be sitting on a 15,000% gain. Not too shabby, but consider that your $5,000 investment would be worth $750,000 -- paltry compared with the $2 million if you'd pulled the trigger back in 1990.
But remember, great companies invariably reach critical mass. You could still run out and buy Intel (NASDAQ:INTC) this minute. And maybe you should -- but can it really be the next big winner? With a market cap in the hundred billions, what are the chances it can run up another 1,000% in value? Pretty slim.
What you need is proof
Of course, I can't claim with any certainty that micro-cap stocks will continue to outperform over the next 20 years. Or that we can find the next big winners. I can't even promise that micro-cap value stocks will outperform. But they have done so in the past.
In "Worst-Kept Secret," I showed how, since 1926, small-cap stocks have thumped large caps -- with small-cap value stocks faring best. That's according to Ibbotson Associates, which also ran the numbers for micro caps, this time from 1968 to 2002. Turns out, micro-cap value stocks take the cake.
Consider: $10,000 invested in micro-cap value back in 1968 had grown to nearly $1,050,000 a quarter-century later. Compare that with around $950,000 for the same amount invested in small-cap value (which, remember, is phenomenal) and a mere $180,000 for large-cap growth.
Nervous Nellies need not apply
Micro caps are for investors who can stomach a little volatility. OK, a lot of volatility. The stocks of smaller companies are more jumpy than all others. There are reasons for this, ranging from low liquidity to uneven news flow to execution glitches associated with rapid growth and sensitivity to the business cycle. Volatility? Expect it.
And when it comes to business or company risk -- heck, even sector risk -- it pays to diversify. My pal Rex Moore here at Fool HQ says to allocate "one full stock position" to a basket of micro-cap stocks. I can't promise I will muster that kind of discipline myself, but I certainly see the value in it. Just be careful.
The best approach is to look for growth potential and real earnings -- at a reasonable price. I'm betting that sounds like a whole lot of fine print, warnings, and disclaimers. But did I mention the potential rewards? Out of this world.
Don't think performance doesn't count
In previous columns, I promised to keep you posted on Tom Gardner's Motley Fool Hidden Gems performance. As of Nov. 10, 2005, the recommendations are up, on average, 29.5%. That's compared with 9.6% if you'd invested in the S&P 500 instead.
Micro caps may not be for everyone, but they sure are a blast. And there sure is a lot to talk about. But it's not exactly rocket science, either. More than anything, just promise me you'll keep your head ... and diversify.
What to do now
Or why not rattle Tom Gardner's cage? Tom specializes in small caps, and he's got a regular Hidden Gems feature dedicated to micro caps. And the Tiny Gems online discussion board is superactive.
If any of this sounds good to you, you're in luck. Tom is offering a free 30-day trial that gives you full run of the Hidden Gems service for an entire month. Simply click here to take him up on his offer, and we'll see you there.
This article was originally published on Feb. 4, 2005. It has been updated.
Fool writer Paul Elliott sold Pulte like a dope and owns shares of none of the companies mentioned. Dell is a Motley Fool Stock Advisor recommendation. Home Depot is a Motley Fool Inside Value recommendation. The Motley Fool has a fulldisclosure policy.
