The Secret of Superior Stocks

I was shocked by the 10 best stocks of the past 10 years. These were tiny, obscure companies, yet the returns were incredible. Their most obvious shared trait was their size -- they were all tiny 10 years ago.

But I wanted to know more. I wanted to know how I could have found the best stocks -- the best small caps -- before they were the best.

What'd you do?
Ten is too small a sample size, so I compiled a list of the 100 best-performing small caps of the last decade. While that's still too small to be called a definitive sample, it's large enough to yield some meaningful observations.

With the 100 best small caps in hand, I started testing factors that I thought might correlate with great returns: profitability, dividends, balance sheet strength, and insider ownership, to name a few.

I thought I was on to something.

What'd you find?
Of the top 100 small caps, 69 were profitable 10 years ago. After backing out the eight companies we wouldn't expect to be profitable -- oil exploration outfits and young biotech firms -- I had 75% profitability. So could I say that early profitability correlated with outperformance?

Sadly, no. Using today's small caps as a control group, I found 73% profitability. And there's no way 3,496 stocks can be the 100 best of the next 10 years.

Then what?
My next step was to test for insider ownership. I found that 57 of the 100 best continue to have greater than 5% insider stakes. This seemed low, until I compared it with today's small caps, only 47% of which had similarly sized insider stakes.

That got me thinking more about management, and I started looking at the folks behind the 100 best small caps. Were they founders? How long had they been at the company?

And?
The results were astounding. Sixty-six of the best had founders or a CEO who had more than five years of experience at the helm of the company 10 years ago, and who had stayed ever since. An additional 18 had the same CEO at the helm throughout the company's years of incredible performance. Chico's -- the second best-performing stock of the past 10 years -- is a great example. Chairman Marvin Gralnick founded the company in 1983 and served as CEO until 1993. He returned to lead his company in 1994 when the new CEO resigned. This is a leader who would not let his business down, and the returns for long-time shareholders have been simply mind-blowing.

There are similar stories about the entrepreneurial spirit of leaders like Richard Schulze, Richard Hayne, and Joel Moskowitz:

Compare that performance and longevity with companies like Hewlett-Packard or Home Depot. After crushing the market for decades under the leadership of David Packard, Hewlett has struggled to 9% annualized returns under four different CEOs since 1995 -- with the company only recently showing signs of life. Even Home Depot's returns haven't been the same since General Electric's Bob Nardelli took over for co-founder Arthur Blank.

The Foolish bottom line
While today's average CEO tenure has dropped to less than five years, 84 of the 100 top-performing small caps of the last decade had either a founder or an experienced and devoted CEO leading them to market-trouncing results. That frequency is much greater than in the broader market, and it's the reason why analysis of management has become so important to our research at Motley Fool Hidden Gems.

At the end of the day, there's no simple screen to find winners 100% of the time. Yet among small caps, finding great management can get you one step closer. That's why we're happy that our portfolio of winners includes folks such as Leigh Abrams at Drew Industries.

Our recommendations are beating the market by 15 percentage points to date, and we're confident that we can do even better. By concentrating on small caps and great leadership, we hope to uncover the best stocks of the next 10 years. And we'd love to have you join us. Learn more by being our guest free for 30 days.

This article was originally published on Feb. 15, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Best Buy is a Stock Advisor recommendation. Home Depot is an Inside Value recommendation. No Fool is too cool fordisclosure.