The Case Against Small Caps

It took me nearly 19 years to grasp what you're about to read in the next few minutes.

Now, the case against small caps
We know all about those lucky devils who retired at 35 after stumbling upon Cisco Systems (NASDAQ:CSCO) in 1990 when it was trading for pennies per share (split-adjusted) or even Wal-Mart a quarter-century ago -- before it hit the big time.

But that sword cuts both ways. What about the less-fortunate chumps who got 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. What if the problem isn't with small-cap stocks, but with small-capinvestors?

What if the problem with small-cap stocks is that they attract the wrong crowd? Maybe these gamblers and daredevils all vying for the next home run create 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. 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 at business school 50 grand, and he'll tell you why small caps are risky. Markets are illiquid. Earnings are less dependable and uneven ... capital is costly and hard to secure, especially when times get tough.

But that's not 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 pumping 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 be more boring? They never talk story. They're all assets and cash flows, and valuation.

Sure, they're smart. But they don't earn their full potential, either. Why? Because they're too busy picking over Wall Street's scrap heap. You can beat the market with fallen angels like Ford (NYSE:F) or cash-heavy mega-caps like Microsoft (NASDAQ:MSFT), but let's face it: Their triples and quadruples are behind them. Even if these companies can sort out the difficulties facing them, they're just too old and too big.

The trick, obviously, would be to apply Buffett's old-school valuation techniques to up-and-coming smaller 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 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 trick, of course, is shunning "the next big thing" in favor of small businesses with strong fundamentals at good prices -- in other words, small-cap value. These guys consistently make money in small caps by balancing "story" and "potential" with fundamentals and valuation.

That's how investors found Wal-Mart in the '70s and turned a $5,000 investment into $2.5 million. But what exactly did Wal-Mart have 30 years ago that today's "hot tips" don't? Let's take a look at how 1975 Wal-Mart compares with some of today's heavily traded small caps:

Clearly, 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 are losing money. Moreover, three of the four are struggling to grow revenue.

These are story stocks. Speculating on them could work out in the end, but it may not. 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. According to Ibbotson Associates, 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 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.

So far, Tom has alerted his subscribers to more than 60 small-cap value stocks. More than a dozen of those picks doubled or more, and the portfolio is up on average 33.1%. That's compared to 9.9% 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 great small-cap values (honestly, I don't know why I'm harping on Harvard today, though never rule out envy). You can get Ben Graham's Security Analysis at the library, if you're up for flipping 700 pages. But there may be an easier way.

Why not try Hidden Gemsfree for 30 days? Enjoy the entire Hidden Gems service for a month (including Tom's full stock scorecard and all back issues), and then decide if you want to join. This way, 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 of Tom's picks on hisscorecardwith your free trial. Paul owns shares of Genta. Microsoft and Wal-Mart are Inside Value recommendations. The Motley Fool has adisclosure policy.