The Case Against Small Caps

Enough already with those lucky devils who retired at 35 after stumbling on Intel (NASDAQ:INTC) in the mid-1980s! I mean, that sword cuts both ways, right?

What about the less-fortunate chumps who got wiped out when their hot stock tip suddenly went belly-up? Isn't that the "problem" with buying small-company stocks, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School, and they'll tell you the same thing. Be sure to pack a few hundred grand in small bills, though. Or save yourself some money and consider something else. What if the defect isn't with small-cap stocks, but with small-cap investors?

What if the problem with small caps is that they attract the wrong crowd? Maybe all those gamblers and daredevils, vying for the next home run, simply create the "illusion" of a wacky and treacherous market.

Don't take my word for it -- reams of data support that contention. But here's something more important than any piece of data: how you can use this "illusion" to make money.

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

All true, but I'm not convinced that's why so many small-cap investors lose their shirts. It's more insidious than that. It's because they don't invest. Rather, they speculate on stock tips and high-risk story stocks with low-quality -- or worse, no -- real earnings. It's that simple.

Small-cap investors -- too many, at least -- ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small, unknown company 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 fuss over mature large-cap, cigar-butt-and-smokestack companies trading at bargain prices. Could these guys be more boring? They never talk story or potential. They're all hidden assets, 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. I mean, you can make money on fallen angels like Ford (NYSE:F), but their triples and quadruples are mostly behind them. Same goes for well-understood mega-cap tech stocks like Qualcomm (NASDAQ:QCOM). They're just too big.

But what if we could take the old-school valuation techniques made famous by Ben Graham and Warren Buffett and apply them to up-and-coming smaller companies, while their growth spurts are still ahead? Again, I know it sounds simple, but you'd be amazed at 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 people like Chuck Royce and David Nierenberg (whom we had the pleasure of meeting here at Fool HQ recently), Tom and his crew over at Motley Fool Hidden Gems are among the few folks I've seen cashing in on this little "trick."

The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals selling at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing the fun stuff -- "story" and "potential" -- with old-fashioned fundamentals and valuation.

That's precisely what led investors to Wal-Mart in the '70s. They turned a $5,000 investment into $2.5 million. But what was so great about Sam Walton's general store back in 1975? A few things. Take a look at how Wal-Mart compared with some of today's heavily-traded small caps:

Clearly, while Wal-Mart was rapidly expanding revenues and profits back in 1975, that's not the case with the other companies in the table. In fact, those companies don't actually have earnings.

Which isn't to say they don't have potential. The problem is they are all "potential." Speculating on companies like these may work out for you, but it also may not. The safer play is to dig up small caps like Wal-Mart -- when they're still small -- 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 nearly 70 years to do it, but 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 subsequently doubled or more, and as of this morning, the entire portfolio is up 56% on average per pick. That thumps the respectable 21.4% return of the S&P 500.

How about some really good news?
You don't have to pay Harvard to find great small-cap values anymore. You can pick up Ben Graham's Security Analysis on Amazon. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- and there's no heavy reading or speculation required.

You can join Tom Gardner and Bill Mann at Hidden Gems free for 30 days. Check out the complete Hidden Gems service for a full month, including all of Tom and Bill's recommendations and every issue they've ever published. Then take a whole month to decide whether you want to sign up.

I guarantee that you'll meet lots of friendly and knowledgeable folks, and they won't pressure you to subscribe. Best of all, the first lesson is always on Tom. To take advantage of this special free trial, 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 Hidden Gems picks on his scorecard with your free trial. Paul does not own shares of any company mentioned. Intel and Wal-Mart are Motley Fool Inside Value recommendations. The Motley Fool has a disclosure policy.