If you invest in stocks for the long term, you must own small caps.
There, I said it. But that's not personal investment advice at all. That's Wall Street's worst-kept secret: Over the long haul, small-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 let's talk about you. You are serious about this stuff; otherwise, you wouldn't be reading. You also want an edge -- a secret -- that will help you do better than the average investing Joe. We all want that edge.
So why make this difficult? Investors who make the most over the long term hold common stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. Stock investors who do even better 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 we 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 Tom Gardner, who recommends well-run small companies to his Motley Fool Hidden Gems subscribers -- 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 -- I would swap 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. 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 trading the likes of Wal-Mart
So what are going to do? Take a chance on some fly-by-night outfit? Good point. But, remember, I said well-known stocks -- not companies. There's a difference. eBay
Contrast that to an outfit like Southwest Airlines
Some 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 shareholders nearly 30% per year. With a little work, we can do it, too.
Here's how I know you can do it
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
The fact is, it can take a long time for a stock to cross the big boys' radar, even if the traders and analysts 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.
All this gives us a great advantage as individual investors. The trick, of course, is to find these stocks and buy them before the big money drives them to the stratosphere.
Here's an easy way to get started
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 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, 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 small-cap exposure. The strategy of holding the funds, and then shifting into Tom Gardner's Hidden Gems, strikes me as particularly shrewd.
The proof is in the numbers
Earlier, I promised you numbers. According to Ibbotson Associates, small caps have earned 12.4% annually since 1926. That's compared with 10.7% for large caps. That means that $5,000 invested in small caps can grow into about $52,000 over 20 years. Imagine if you add to your position along the way.
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, you can't deny that today's giants sprouted from well-run small companies and that investors cashed in. So will tomorrow's.
What to do now
I promised to keep you posted on Hidden Gems' performance. As of Feb. 3, 2006, the recommendations were up, on average, 38.4%. That's compared with just 11.6% if you'd invested in the S&P 500 for the same period.
You can learn more about Tom Gardner's approach to beating the market with small-cap value without sticking your neck out. 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. To give it a shot, simply click here.
This article was originally published on Jan. 7, 2005. It has been updated.