If you own stocks, you should own small caps.
Of course, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks outperform their mid- and large-cap peers.
I know you're serious about this
Otherwise, you wouldn't still be reading. And you know you want an edge. We all do. So, why make this difficult? Everybody knows that investors who make the most over the long term buy common stocks.
At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who make even more buy small caps, also according to Ibbotson.
The way I see it, we have a few choices. We can take a chance on a fund that keeps its costs in check. We can buy a low-cost small-cap exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.
You're a Fool ...
and so am I
We favor the do-it-yourself approach. Well, sort of. You see, I've been a small-cap guy for years, but I also have the occasional cup of joe with Tom Gardner. If you don't know Tom, he digs up well-run small companies for his subscribers at Motley Fool Hidden Gems -- and he never shuts up about it.
And you know what? I'm man enough to admit that Tom is putting together a decent portfolio of small caps I probably couldn't have built on my own. What's his advantage? I think it's that he focuses on value, while I tend to focus a bit too much on story.
Yet for all our differences, Tom and I do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. Smart investors have always looked for:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
It's hard to imagine now, but back in 1987, these same traits gave investors the moxie to follow a former newsletter writer into battle against Wall Street. Folks who bought the Schwab
Good work if you can get it
I know. Who in his or her right mind wouldn't want a portfolio filled with stocks like that -- at least in their prime? And you're right. That's why it's so hard to beat the pros with those same stocks today -- if they're really all that now, everybody knows it.
So what's the alternative? Taking a chance on some fly-by-night outfit? Good point. But here's the catch: Just because a stock isn't heavily owned and followed on Wall Street doesn't mean in it's a seat-of-the-pants start-up. How about another example?
My local hero, Under Armour
Need more proof?
Tim Hanson recently tracked down the best-performing stocks of the past 10 years. Check them out. But don't expect to find story stocks like Sirius Satellite Radio
But wait, that's good news. That means you can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. Peter Lynch was a master at finding these stocks. That's how he earned his Fidelity Magellan fundholders nearly 30% year after year.
How to get rolling
Back in September 2003, I suggested you take a look at a pair of small-cap ETFs. I'd bought the iSharesS&P 600 Growth Index (IJT) 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 (IJS), next -- a promise thankfully kept.
Even after the recent small-cap pullback, the growth fund is up some 90% in a little less than three years. The value fund has fared even better. Apparently, folks who pronounced the small cap dead back in September 2003 were wrong. (My hunch is that there are even more doubters now -- and that they're still wrong.)
More importantly, these funds trade like stocks, giving you quick and dirty small-cap exposure without the stress of taking the plunge on the stocks of individual companies.
What to do now
If you ask me, a strategy of holding either one of these funds and then shifting gradually into the stocks Tom recommends in Hidden Gems is solid. But sooner or later, you probably want to be exposed to at least a few small businesses with big potential. That's where the fun is.
Meanwhile, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 39.8%. That's compared with 18.1% if you'd invested in the S&P 500 for the same period. Not bad.
If you'd like to learn more about how Wall Street's worst-kept secret can help you beat the market, Tom Gardner is offering a free trial to his complete Hidden Gems service. You can take it up directly with him and sneak a peek at all of his recommendations and back issues. To learn more, simply click here.
This article was originally published on Jan. 7, 2005. It has been updated.
Fool writer Paul Elliott owns shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. Columbia Sportswear is a Hidden Gems recommendation. XM Satellite Radio and Under Armour are Motley Fool Rule Breakers recommendations. Schwab and American Eagle are Stock Advisor picks. The Motley Fool has a fulldisclosure policy.