Small-cap stocks sure bounced around in 2005. The Russell 2000, the leading index for small-cap stocks, was down more than 11% at one point, then it hit all-time highs over the summer and ended the year up approximately 3%. And it has started 2006 up 6%. Should you book profits now, afraid of the next downturn? Let's be contrary and abandon emotion! Instead, we need a quick history lesson.
Master investors who've used market declines to build out their positions in great companies have accumulated enormous wealth. When valuations collapse, they don't run for the hills; they run in from the hills to buy more. And instead of trying to time the market with a quick sale, they have proved that the best way to build wealth is to hold on for years after the first new highs have been hit.
Take a look at a company like Adobe Systems. The software publishing firm went public in 1986. The market collapsed a year later, and Adobe's market cap was cut in half. Yet the small cap had a super-strong balance sheet, dedicated leadership, and a widening market opportunity.
Now here we are 20 years later. Adobe is still supervised by its two founders, John Warnock and Charles Geschke. During the years, Adobe's stock has fallen 50% or more on six separate occasions. There've been numerous short-term periods when owning Adobe felt like a magnificent mistake. Heck, from September 2000 to September 2002, Adobe dropped 75% as technology stocks were sold indiscriminately.
Yet over these 20 years, Adobe Systems has risen 60 times in value, turning a $10,000 investment into $600,000. That amounts to 25% yearly growth with taxes deferred. It's a market-crushing return. It's a thing of beauty that doesn't even include the dividends Adobe began paying in 1990.
This is exactly the sort of business we stalk in Motley Fool Hidden Gems, since it features the following traits:
- Devoted leadership
- A sound balance sheet
- Early dividend payments
- A wide market opportunity
- A broken stock price
In case you think Adobe Systems is an isolated example, look at the commercial characteristics and investment returns of Cincinnati Financial (NASDAQ:CINF), Target (NYSE:TGT), Becton, Dickinson (NYSE:BDX), Nordstrom (NYSE:JWN), and Ross Stores (NYSE:ROST). Each suffered numerous 30% to 50% declines in the journey from small to large cap. Yet with dividends reinvested, each absolutely crushed the market's return over the past 10 to 30 years
We've found a number of these companies. And so it only makes sense that we're pleased as pudding by the opportunity to add to them when the market declines, and we're more than willing to hold onto them when the market is up. You can view my favorite small-cap companies now by subscribing to Motley Fool Hidden Gems. Our picks are already beating the S&P 500 37% to 13%, and we expect this outperformance to continue. But if you don't think we can help you earn better returns, we'll gladly give you a refund.
This article was originally published on May 9, 2005. It has been updated.
Tom Gardner is co-founder of The Motley Fool and lead analyst of Motley Fool Hidden Gems. Tom does not own shares of any company mentioned in this article. The Fool has a disclosure policy.
