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 gamble on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.
You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I've been buying small caps for years. But I also have the occasional cup of joe with Tom Gardner, who's made a career of finding well-run small companies for his subscribers at Motley Fool Hidden Gems.
And you know what? I'm man enough to admit that Tom is building a portfolio of small caps I probably wouldn't have found on my own. What's his secret? I think it's that he focuses on quality and value, while I tend to get wowed by 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.
Good work if you can get it
Then again, who wouldn't want a portfolio filled with stocks like that? And you're right. That's precisely the problem with trying to beat the pros with well-known, large-cap names -- if they're really all that, they're going to cost you.
So, what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference. I bet you knew the ticker symbol for eBay (NASDAQ:EBAY) long before you won your first auction. Google (NASDAQ:GOOG), by contrast, was a verb long before it went public.
Yahoo! (NASDAQ:YHOO), curiously, seemed to hit Main Street and Wall Street at the same instant. Yet, all three companies were crawling with Wall Street analysts before you or I could get an edge. But what about Abercrombie & Fitch (NYSE:ANF) and American Eagle Outfitters (NYSE:AEO)? More than 20 analysts cover them now, but most investors heard those names from their kids long before their brokers.
And those are just two examples. There's always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Peter Lynch was a master at finding these stealth bombers. Remember, there were a number of unassuming retailers like Gap (NYSE:GPS) that helped earn Lynch's Fidelity Magellan fundholders nearly 30% year after year. With a little work, you can do it, too.
Need more proof?
Tim Hanson tracked down the best-performing stocks of the past 10 years. Check them out. But don't expect to find story stocks and Wall Street regulars on the list. Instead, look for solid businesses that started as underfollowed stocks. Celgene (NASDAQ:CELG), for example, was a mid-tier pharmaceutical company with a line of proven drugs, and it climbed more than 6,100% over 10 years.
That's great news for investors like us. It means we can find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets.
How to get rolling
Way 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.
The growth fund has doubled in three years. The value fund has fared even better. Apparently, folks who pronounced the small-cap rally 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 buying either one of these funds and then shifting gradually into the stocks Tom and his team recommend in Hidden Gems is solid. But, sooner or later, you'll probably want to own 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. As of this morning, the recommendations are up, on average, 61.7%. That's compared with 27.2% 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, now's the time. 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 every one of his back newsletter issues. To learn more about this special trial, simply click here.
This article was originally published on Jan. 7, 2005. It has been updated.
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. eBay, Yahoo!, and Gap are Stock Advisor picks. Gap is also an Inside Value pick. The Motley Fool has a full disclosure policy.
