Where were you the evening of Sept. 26, 2003? And did you have more money than you have now ... or less?
Me, I was working on a column a lot like this one. In fact, it was just like this one. And looking back, I may have stumbled on two small ideas that could have made us both some money.
Don't worry, you can still cash in
In case you weren't with us back in 2003, I'll give you the quick rundown. After all, I think the bull case is as compelling today as it was then.
- I still don't believe the rally in small-company stocks is kaput.
- If you don't have small stocks in your portfolio, don't assume you're covered by your mutual funds. Not even so-called "total market" funds.
I'll explain why in a moment. But first, back to September 2003, when a lot of "experts" were driving the nail in the small-cap rally's coffin. I didn't buy it then (and I hope you didn't, either).
Instead, I boasted shamelessly about how I had loaded up on the iShares S&P SmallCap 600 Growth (IJT) the previous January at around $65. Then, I suggested you still had to join me and make some money. If you did, you're sitting on another 55% gain. And that's on a diversified index after the recent pullback. Well done.
Why you should keep it small
I won't rehash my argument for why I liked small caps then, but a few points are worth noting. First, we were coming out of a recession, and small-cap growth stocks are notoriously hot during recoveries. More important, we hadn't nearly made up the ground lost during the '90s mega-cap lovefest.
Don't sleep on this last point. I think it still holds. Sure, we catch some grief around here for constantly pointing out how difficult it would be for massive operations like Altria (NYSE:MO) or Procter & Gamble (NYSE:PG) to double their $100- and $70-plus billion in revenues. But it's true -- and even that's not the worst of it.
After all, even if these guys make all the right moves, we still might not see the glory days of the '80s again. In fact, there is any number of large-cap stalwarts whose revenues and earnings have been solid, yet whose stocks have failed to break out since we last spoke in September 2003. That, my friend, is what I call a painful morning after.
But
we're
just getting buzzed
Plus, even if I am irrationally exuberant about small caps, it's not the end of the world. In my view, the advantages of small companies extend beyond relative valuations. Small companies are simply more agile and better poised for growth than the behemoths we hold in our "total market" index funds.
That's why I'm a fan of Tom Gardner's Motley Fool Hidden Gems approach. For one thing, Tom invests from the bottom up. When you focus on specific companies, you don't need strength in a sector, cap size, or investment style. And if you focus on small companies, you get another bonus -- if you know how to play it.
Remember, there's less information out there on smaller, more thinly traded stocks, making the market less efficient. Moreover, as Tom is fond of explaining (over and over and over), the lack of interest in these stocks keeps you out of crowded auction-house bidding wars like the one that broke the bank for large-cap investors in 2000.
The problem with your mutual funds
Don't assume you're covered because you own broad market stock funds, even so-called "total market" funds. In fact, these funds are dominated by large-cap growth stocks. Which means that, among other things, you're holding more $105 billion Verizon (NYSE:VZ) than $21 billion Alltel (NYSE:AT).
In other words, you may think you own equal chunks of 3,705 stocks, but you don't. Even a so-called total market fund gives you much more exposure to a $180 billion AIG (NYSE:AIG) -- and financial stocks in general -- than you may think. As for No. 3,705 (whatever that is), you barely have any.
In fact, just 10 massive stocks make up more than 16% of your "total market" portfolio. That's why a one-day sell-off in Johnson & Johnson or one of the major banks or energy stocks sends you running for the Alka-Seltzer, while a 10-year 10,000% gain in little Chico's FAS (NYSE:CHS) barely buys you lunch.
Famous last words
Finally, even if you agree that mega caps are due, you still shouldn't dump your small caps. History proves that many (if not all) of tomorrow's Goliaths are little Davids today. And unlike with the mega caps we've discussed today, an extra $1 billion in earnings could propel you into a whole new tax bracket.
If that sounds like some sweet action, you really should give Hidden Gems a try. Tom and his team of analysts have turned up a dozen or so stocks that doubled in value, including one 500%-plus gainer. And Tom has me convinced that a 10-bagger is sitting on his buy list right now.
So, if you're looking for small-cap ideas, that's where I'd start. And here's another reason: You can check out every one of Tom's picks the instant you start your trial (you can even print out the scorecard). If you're not impressed by what you see, simply don't subscribe ... and don't pay a nickel. To take a free peek, click here.
This article was originally published on March 24, 2006. It has been updated.
Fool contributor Paul Elliott promises to keep you posted on the progress at Hidden Gems. As of this morning, the picks are up 45.3%, versus 17.2% if you'd bought the S&P 500 instead. You can view them all on our scorecard with your free trial. Paul owns the iShares S&P SmallCap 600 Growth ETF as well as Johnson & Johnson, which is an Income Investor recommendation. Alltel is also an Income Investor pick. The Motley Fool has a disclosure policy.
