Where were you on 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. And looking back, I may have stumbled on two facts that could have made us both a lot of money.
And you can still cash in
So, just to be safe, I'll repeat them right now:
- I still don't believe the rally in small-company stocks is over.
- If you don't have small companies in your portfolio, don't assume you're covered by your mutual funds. Not even if they're so-called "total market" index funds.
I'll explain why. But first, back to September 2003, when a lot of "experts" were declaring the small-cap rally dead. I didn't buy it (and I hope you didn't, either).
Instead, I told you how I'd bought the iShares S&P SmallCap 600 Index (IJT) the previous January at around $65, for a quick 25% gain. Next, I suggested that you still had time to get in yourself and still profit. If you did, you're up another 85%. Well done.
Why you should keep it small
I won't rehash my entire argument for why I like small caps, but a few points are worth noting. First, we were coming out of a recession, and small-cap growth is notoriously hot during recoveries. More importantly, we hadn't nearly made up the ground lost during the '90s mega-cap lovefest.
Don't sleep on this last point. I catch grief for constantly pointing out how difficult it would be for a massive operation like General Motors (NYSE:GM) to double its $200 billion in revenue even if it offered all the buyer incentives known to man.
But even if GM does everything right, the stock could still let you down. After all, look at large-cap stalwarts such as Abbott Labs (NYSE:ABT) and Coca-Cola (NYSE:KO), one of which I own myself. Revenue and earnings have been solid, yet the stocks have done little 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.
Which is why I'm a fan of Tom Gardner's Motley Fool Hidden Gems approach. For one thing, he invests from the bottom up. When you focus on specific companies, you don't need across-the-board strength in a sector or investment style. And if you focus on small caps, you get another bonus -- if you know how to play it.
There's less information out there on smaller, more thinly traded stocks, making the market less efficient. Moreover, as Tom is fond of explaining, 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. All of which adds up to superior returns.
Finally, 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 a lot more $60 billion old-school SAP (NYSE:SAP) than $5 billion upstart Red Hat (NYSE:RHT).
Put another way, you may think you own equal chunks of 3,699 stocks, but you don't. Even in a so-called total market fund, you'll always have much more exposure to a $265 billion Citigroup (NYSE:C) -- and financial stocks in general -- than you may think. As for No. 3,699 (whatever that is), you barely have any.
In fact, just 10 massive stocks make up more than 15% of your "total market" portfolio. That's why a one-day sell-off in energy stocks or the major banks sends you running for the Alka-Seltzer, while a two-year 300% gain in tiny drink-maker Hansen Natural (NASDAQ:HANS) barely buys you lunch.
Don't make this mistake
And even if you agree that mega caps are due, you still shouldn't dump your small stocks. History shows that many (if not all) of tomorrow's Goliaths are Davids today. And unlike with Oracle or Citigroup, an extra $1 billion in earnings could propel you into a whole new tax bracket.
If that sounds like some sweet action, you should give Hidden Gems a try. Since 2003, Tom and his analysts have turned up a dozen stocks that doubled in value or more, including one 500%-plus gainer. And he has me convinced that a 10-bagger is on his buy list right now.
If you're looking for small-cap ideas, that's where I'd start (Hidden Gems was recently named the No. 1 investment newsletter by Hulbert Financial Digest for the past 12-month returns). You can check out all Tom's picks the instant you start your trial. If you're not impressed, don't subscribe and don't pay. To have a look, 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 63%, versus 27% if you'd bought the S&P 500 instead. You can view them all on our scorecard with your free trial. Paul owns iShares S&P SmallCap 600 ETF and Coca-Cola, which is an Inside Value pick. The Motley Fool has a disclosure policy.
