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
Have you heard the one about the farmer from San Jose who bet the ranch on Cisco Systems (NASDAQ:CSCO) in 1990 and retired 10 years later -- conveniently before Cisco lost 75% of its value? In my Dad's day, it was upstate New York, and the lucky devil bought IBM (NYSE:IBM) in 1962.

Either way, it's a good story. But that sword cuts both ways, right? After all, what about the less-fortunate chumps who get wiped out when their hot stock tip suddenly goes belly-up, leaving them holding the bag?

Isn't that the "problem" with buying small, lesser-known 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 grand in small bills. Or save yourself a few hundred thousand 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 caps is that they attract the wrong crowd? Maybe it's all those gamblers and daredevils vying for the next home run that creates an "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 market data is how you can use this "illusion" to make money.

Why small-cap investors get creamed
Heck, even a finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are less dependable and lumpy ... capital is costly and hard to secure, especially when times get tough.

All true. 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 he 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.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. You can make money on fallen angels like Pfizer (NYSE:PFE) or cash-heavy megacaps like Johnson & Johnson (NYSE:JNJ), but their triples and quadruples are behind them. They're just too old and too big.

The trick, obviously, would be to apply Warren Buffett's old-school valuation techniques to up-and-coming smaller companies with their big growth still ahead. 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've seen 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 what led investors to Wal-Mart in the '70s, turning a $5,000 investment into $2.5 million. But what exactly was so great about Sam Walton's general store back in 1975? Take a look at how Wal-Mart compared with some of today's whisper-stock party tips:

Clearly, while Wal-Mart delivered rapidly expanding profits and revenues back in 1975, that's not the case at the four companies I just showed you. In some cases, revenues are picking up, but all four are losing money.

You see how these stocks are all "potential." Speculating on them could work out for you, but it may not. The safer play is to dig up small caps like Wal-Mart that can make you a lot of money methodically over the years.

After all, this "trick" turned $1,000 into $33 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 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 26% on average. That's compared to 10% 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. You can get Ben Graham's Security Analysis at the library. If you're up for flipping 700 pages, that is. But there may be an easier way.

Why not join Tom at Hidden Gemsfree for 30 days? Enjoy the complete Hidden Gems service for a full month (including access to Tom's stock scorecard and all back issues), and then decide whether you want to join. No pressure. And 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 Applied Digital (don't ask!). Pfizer and Wal-Mart are selections of the Inside Value newsletter service. Johnson & Johnson is an Income Investor pick. The Motley Fool has adisclosure policy.