The Case Against Small Caps

It took me nearly 20 years to grasp the implications of what you're about to read in the next few minutes.

Now, the case against small caps
Sure, we know all about those lucky devils who retire at 35 after stumbling upon Intel (NASDAQ:INTC) in the mid-'80s or even Wal-Mart a quarter-century ago -- before it hit the big time.

But that sword cuts both ways, right? What about the less-fortunate chumps who get wiped when their small-cap wonders suddenly go belly-up, leaving them holding the bag?

Isn't that the "problem" with small-cap stocks, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School, and they'll teach you the same thing -- though be sure to pack a few hundred thousand in small bills. Or save yourself a few bucks and consider something else instead. What if the problem isn't with small-cap stocks, but with small-capinvestors?

What if it's because they have so much potential that small-cap stocks attract gamblers and daredevils? Maybe it's these reckless spirits, all vying for a shot at the next home run, that creates the illusion of a wacky and treacherous market.

Maybe nothing. That's precisely what happens. And don't take my word for it. Reams of data support that very contention; I'll even show you some in a bit. But more important than any piece of data is how you can use this "illusion" to make money.

Why small-cap investors get creamed
Slip the dean that first 50 grand, and his minions will tell you why small caps are risky. Markets for small stocks are illiquid. Earnings are less dependable and uneven ... capital is more costly and hard to secure, especially when times get tough.

But none of that is the real reason why small-cap investors get pummeled. It's more insidious than that. It's because they don't invest -- they speculate on stock tips and super high-risk story stocks with low-quality (or worse, no) real earnings. It's that simple.

Small-cap investors ignore fundamentals. At least, too many do. If you don't believe me, ask yourself this: When was the last time you heard some guy hocking a small-company stock at a party or on TV, and the fellow wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who focus on mature large-cap, cigar butt, and smokestack companies trading at bargain prices. Could these guys possibly be more boring? They never talk story. They're all balance sheets, assets, cash flows, and, worst of all, valuation.

Sure, they're smart. But they don't earn their maximum potential, either. Why? Because they're too busy picking over Wall Street's scrap heap. You can beat the market if fallen angels like Pfizer (NYSE:PFE) and General Motors (NYSE:GM) come back and you've been reinvesting dividends, but let's face it: Their triples and quadruples are behind them.

The trick, obviously, is to apply old-school valuation techniques -- "secrets" passed down by value hounds like Ben Graham and Warren Buffett -- to up-and-coming small companies. Again, I know it sounds simple, but you'd be amazed how few investors even give it a shot.

Forget the "next home run stock"
If you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with a handful of folks like Chuck Royce and David Nierenberg, Tom and his crew at Motley Fool Hidden Gems are among the few I know who are cashing in on this little "trick."

The little trick, of course, is shunning "the next big thing" in favor of small businesses with strong fundamentals at reasonable prices -- in other words, small-cap value. Put another way, these guys consistently make money in small caps (more on that in a bit) by balancing "story" and "potential" with fundamentals and valuation.

As Tom will tell you, this is what led investors to Wal-Mart in the '70s and turned a $5,000 investment into $2.5 million. But what did Wal-Mart have 30 years ago that today's little wonders don't? Let's take a look at how 1975 Wal-Mart compares with some of today's most heavily traded small caps:

While Wal-Mart boasted rapidly expanding profits and revenues back in 1975, that's not the case at the four companies I just showed you, which have no profits to speak of. Moreover, three of the four are struggling to grow revenue.

Companies like that are all story. And while speculating on them could work out in the end, it's a long shot. The safer bet is to find small caps like Wal-Mart (or even anything close) that can make you a lot of money methodically over the years.

After all, this "trick" turned $1,000 into $30 million. Granted, it took 70 years to do it, but still. And that's according to Ibbotson Associates, a firm that's been collecting market data for nearly a century. According to Ibbotson, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps. And more than 15 times better than if you'd bought large caps (the stocks everybody loves) instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for just a couple of years now, but take a look and judge for yourself.

Over the past few years, Tom has alerted his subscribers to more than 50 small-cap value stocks. More than half a dozen of those picks have doubled or more, and the portfolio is up on average 36.6%. That's compared to 12.9% if you'd bought the S&P 500 instead.

Now, for the really good news
You don't have to pay Harvard to find these market-thumping stocks (honestly, I don't know why I'm harping on Harvard today, though never rule out envy). Heck, you can get Ben Graham's Security Analysis at the library, if you're up for poring over 700 pages. But you know what I would do?

I'd try Hidden Gemsfree for 30 days. You get full access to the entire Hidden Gems service for an entire month (including Tom's full stock scorecard and every single back issue), and there's no obligation to subscribe. This way, no matter what you do with the rest of 2006, the first lesson is on Tom. To see how easy it is, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all Tom's picks on hisscorecardwith your free trial. Paul owns shares of Pfizer, which is a recommendation of Inside Value. Encysive Pharma is a Motley Fool Rule Breakers recommendation. The Motley Fool has adisclosure policy.