Hurricanes can be pretty savage storms. Thankfully, those in harm's way usually have time to react to the situation. Investing is just like that. Prepare for your financial future the way one would gear up for a killer windstorm and you can fortify your portfolio with enough fiscal duct tape and plywood to see it through the rough patches.
Earlier this week, we tagged investing styles with storm categories.
- Category 1 took a peek at high-yielding investments.
- Category 2 took a look at value stocks.
- Category 3 approached the merits of a balanced portfolio.
Category 4 investing takes us one step further when it comes to intensification. Today we will explore small-cap stocks. Our Motley Fool Hidden Gems newsletter service specializes in unearthing small companies and the allure is obvious. Patient investors are backed by historical returns that favor small-cap stocks over the long haul.
It's not perfect, though. It can be a minefield. Chasing superior returns entails accepting superior risk. I stumbled on an old portfolio tracker I had set up a dozen years ago and was shocked to see that most of the companies had vanished. Where art thou, Koala Kare, Lancit Media, and Healthy Planet?
Scouting for superstars at the fiscal farm club
The real draw to snapping up small caps is in landing a home run stock. That's where legendary investors earn their stripes. Adobe (NASDAQ:ADBE) is an undisputed giant in publishing and media software these days, but there's always that person who bought in soon after the company went public 20 years ago and is sitting on more than a 40-bagger today. Maybe it's the lucky investor that bought into Amgen (NASDAQ:AMGN) back in 1990 at a split-adjusted price of less than a buck. That cat is sitting on a 65-bagger today.
Those are great stories worth telling, but I think the real reason to consider small companies is that the markets are highly inefficient there. You don't need a small company to graduate into mid-cap camp or blue-chip high school to beat the market. You just need to buy in at the right time.
Trust me, it's easier than it sounds. If there's a company you like, just pull up a quote that shows the number of analysts providing earnings estimates. Big tech bellwethers like Google (NASDAQ:GOOG) or Yahoo! (NASDAQ:YHOO) have close to 30 star analysts munching corporate data with their profit models. Aim lower.
Going over the past year of picks that Tom Gardner has made for Hidden Gems subscribers, more than half of them have five or fewer analysts following them. That should encourage you. Next step? See how out of step those analysts have been in the past. How do you do that? Just see whether there are more quarters over the past year in which the company has beaten Wall Street estimates over simply meeting them or coming up short.
My quest found three gems among Tom's Gems.
| Analysts | Beat the Street* | |
|---|---|---|
| Ctrip.com (NASDAQ:CTRP) | 4 | 3 times |
| Blackboard (NASDAQ:BBBB) | 5 | 4 times |
| Drew Industries (NYSE:DW) | 4 | 3 times |
Putting it all together
Your quest doesn't have to end there. One of Tom's best-performing picks -- an oven maker that has appreciated better than fourfold since being singled out less than three years ago -- has just five analysts watching and has pounded them silly in three of the last four quarters.
Of course, there are risks. The lack of institutional coverage can come back to bite investors when the companies unleash negative surprises. There will be implosions. Because we're talking about obscure companies, you never hear too much about that, but you have to accept that it happens when you're tracking down shadow stocks.
Is taking on the extra risk worth it? Category 4 investors would probably have to nod in agreement. Tom's average pick for Hidden Gems has soared a respectable 21.96% higher, while the S&P 500 has notched an average gain of just 8.56% over the same time. Guest analysts that Tom has invited to share their single best investing ideas have often fared even better.
Good things do come in small packages, even landscape-altering windstorm stocks.
Are you a Category 4 investor or want to learn more to see if you are one? Give Hidden Gems a spin with a free 30-day pass to see whether small-cap investing is right for you.
Longtime Fool contributor Rick Munarriz believes you need to start small if you want to think big. He does not own shares in any of the companies in this story. The Fool has a disclosure policy. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.
