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 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 on the call from New York. He's got to be the worst of the lot.
The greatest stocks of all?
A while back, I made the case for "Wall Street's Worst-Kept Secret." In a nutshell, it's that small-cap stocks tend to outperform their larger-cap peers over time -- and that successful stock investors own them. What, then, is Wall Street's best-kept secret?
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 some hard 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 difficult to find detailed information 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 pretty well over the years. But in a sense, we're just winging it. Our method was never especially rigorous, and to this day, the rumor mill deals largely in high hopes and speculations.
But tiny doesn't have to mean risky
What if I told you Wal-Mart once boasted a market cap of less than $30 million? Yet even then the company made money. It was shareholder-friendly, conservatively managed, and heavily owned by obsessive founders.
If you'd invested $5,000 in Wal-Mart in 1980, you'd be sitting on about $2.5 million today. Hindsight is 20/20, of course, 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. 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 of all, look for micro caps that pay 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 never could have found Wal-Mart? Well, how about Best Buy (NYSE:BBY) or Target (NYSE:TGT)? Both looked pretty solid by January 1990. If you'd bought then, you'd be sitting on 14,000% and 5,000% gains, respectively. You could have bought American Eagle Outfitters (NASDAQ:AEOS) -- an original rumor mill find -- as recently as 1997 for similar 5,000% gains.
That's the beauty of getting in early. The rise and fall of AOL (now part of Time Warner (NYSE:TWX)) is the stuff of legends. Investors who bought at the top have thus far been sorely disappointed. Those who bought it back in 1994, however, are still sitting on obscene profits. And then there is Dell (NASDAQ:DELL). Had you bought back in 1990, you'd be up some 40,000%.
But here's the real beauty: Those first few doubles and triples matter. If you'd held off 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 inevitably reach critical mass. You could still buy General Electric (NYSE:GE) and Microsoft (NASDAQ:MSFT) this instant. And maybe you should -- but neither can be the next GE or Microsoft. With market caps in the hundreds of billions, what are the chances either one of those can run up another 1,000% in value? Zip.
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 marveled that 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 downright 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 small companies are simply 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 it pays to diversify. My pal Rex Moore here at Fool HQ says to allocate "one full stock position" to a handful of micro caps. I can't promise I will muster that kind of discipline myself, but I certainly see the value in it. Just be careful.
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 Dec. 8, 2005, the recommendations are up, on average, 37.8%. That's compared with 11.4% if you'd invested in the S&P 500 instead. For context, that's more than 50 picks over two-plus years.
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.
Or why not take the easy way out?
Why not rattle Tom Gardner's cage? Tom specializes in small caps, and he's got a regular Hidden Gems feature dedicated exclusively to micro caps. And the Tiny Gems online discussion board is superactive.
If this sounds good to you, you're in luck. Tom is offering a free 30-day trial that gives you the 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 commentary was originally published on Feb. 4, 2005. It has been updated.
Fool writer Paul Elliott owns none of the stocks mentioned. Dell, Best Buy, and Time Warner are Motley Fool Stock Advisor recommendations. Microsoft is a Motley Fool Inside Value recommendation. You can view the entireHidden Gems scorecardwith your free trial. The Motley Fool has a fulldisclosure policy.
