If you invest in stocks for the long term, you must own small caps.
There, I said it. But that's not personal investment. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks outperform their mid- and large-cap peers, so the successful long-term investors own them. Period.
It's only what you need
Listen, you're serious about this stuff; otherwise, you wouldn't still be reading. You want an edge -- a secret -- that will help you do better than the average Joe. We all do.
So why make this difficult? Investors who make the most over the long term own stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. 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 one of a growing number of small-cap exchange-traded funds (ETFs).
- Take your chances on a small-cap mutual fund that's open for business.
- Seek out the best small 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 owned my share of small caps over the years. But I also have the occasional cup of joe with Tom Gardner, who recommends small-company stocks 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 to build a portfolio of small caps I wouldn't have found 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.
I know what you're thinking .
Who wouldn't want a portfolio filled with stocks like that? That's why it's so hard to outmaneuver the pros trading the likes of General Electric (NYSE:GE) and Disney (NYSE:DIS). Sure, they're American icons, but with so many buyers and sellers poking around, they're going to cost you.
But what's the alternative? Taking a chance on some fly-by-night outfit? Good point. But, remember, I said well-known stocks -- not companies. There's a difference. Yahoo! (NASDAQ:YHOO) and even Amazon.com (NASDAQ:AMZN) panned out for investors, but both were stocks almost before they were companies -- and that made them inherently more risky.
Contrast that with Peter Lynch stocks like Gap (NYSE:GPS) or, more recently, Urban Outfitters (NASDAQ:URBN). Both run hundreds of stores across the country and earned investors massive profits. But both were also name brands long before they were Wall Street darlings.
And there is always a new crop of established, profitable companies with unknown stocks. Some you will have heard of, and some you may not have -- yet. Some even dominate their markets. Lynch was master at finding these stealth bombers, and he earned his Fidelity Magellan shareholders nearly 30% per year.
You can do it, too
After all, I stumbled upon Harley-Davidson (NYSE:HDI) the stock after having seen the bikes for years. In the early '90s, I saw for myself how an upstart medical device maker called Medtronic was fighting for a $25 billion market. (Not surprisingly, the stock is up some 700% since 1995.)
The fact is, it takes 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 of 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 start with a hard look at a pair of small-cap ETFs. I'd bought the iSharesS&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, iSharesS&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 now -- 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.
Ready for some 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. I still don't think the small-cap run is over
What to do now
I promised to keep you posted on Hidden Gems' performance. As of May 4, the recommendations were up, on average, 43.6%. That's compared with 14.3% if you'd invested in the S&P 500 for the same period.
Want to learn more? Take a free trial to Tom's Motley Fool Hidden Gems advisory service. You'll get as many great ideas as you can use. You can even take the subject up directly with Tom and sneak a peek at every one of his current and past picks. To get the ball rolling, simply click here.
This article was originally published on Jan. 7, 2005. It has been updated.
Fool writer Paul Elliott owns none of the stocks mentioned. eBay and Amazon.com are Motley Fool Stock Advisor recommendations. Of course, you can see the full Hidden Gems scorecardwith your free trial. The Motley Fool has a fulldisclosure policy.
