Hey, buddy, want some personal investment advice? 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 mid and large caps.
You're serious about this
And you want an edge. So why make this difficult? Investors who make the most money over the long term buy and hold 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.
So we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy any number of small-cap exchange-traded funds (ETFs). Or we can start building a 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'm a small-cap investor myself, but I have the occasional cup of joe with Tom Gardner. Tom has made a career out of beating Wall Street to the profits on well-run small companies -- and he never shuts up about it.
And you know what? I'm man enough to admit that Tom and his research team at Motley Fool Hidden Gems are building a portfolio of small caps I probably couldn't have found on my own. What's the secret? I think it's that they focus on value, while I tend to get wowed by story.
Yet, for all our differences, we all 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 always look for:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
I know it's hard to imagine, but back in the day, these same traits gave investors the courage to follow Larry Ellison into Oracle -- a software startup that was destined to battle ExxonMobil (NYSE:XOM) and mighty Microsoft (NASDAQ:MSFT) for the top of the market cap heap.
Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio stuffed with stocks like that? And you're right. That's why it's so hard to beat the pros with familiar names like those now -- if they're really all that, they're going to cost you.
But 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. Compare Southwest Airlines (NYSE:LUV) with JetBlue (NASDAQ:JBLU), for example. At one time or another, both satisfied most of Tom's criteria.
Yet JetBlue was a hot stock almost out of the gate. Southwest took years to blip on Wall Street's radar. The same can be said of teen retailers Pacific Sunwear (NASDAQ:PSUN) and American Eagle Outfitters (NYSE:AEO), which even made Tim Hanson's list of the best-performing stocks of the last 10 years.
Need more proof?
Take a moment and check out Tim's list, but hurry back. I'm willing to bet you won't recognize a lot of the ticker symbols. You certainly never heard them from your broker. That's no coincidence. But it doesn't mean you won't know the companies from "real life."
You see, there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Peter Lynch was a master at finding these gems, earning 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 iShares S&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, iShares S&P 600 Value Index (IJS), next -- a promise I thankfully kept.
Even after a brutal month, the growth fund is still up more than 65% since. Apparently, folks who pronounced the small-cap rally dead back in September 2003 were dead wrong. (My hunch is that there are even more doubters now -- and that they're still wrong.)
Best of all, both 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 these funds and gradually scaling into small caps Tom tells you about each month in his Hidden Gems newsletter is a solid plan. Because, sooner or later, you probably want to be exposed to at least a few small businesses with big potential. That's how you hit home runs.
Meanwhile, I promised to keep you posted on the performance of Hidden Gems -- in good times and bad. As of today, the recommendations are up, on average, 54.5%. That's compared with 21.2% if you'd invested in the S&P 500 for the same period. More than a dozen picks have doubled in value at least. Not too shabby.
If you want to learn more about Wall Street's worst-kept secret, now's the time. Tom is offering a 30-day free trial to his complete Hidden Gems service. You can take it up directly with him and sneak a peek at every one of his current and past recommendations -- plus all the back newsletter issues. Best of all, there's no obligation to subscribe. To learn more, 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. JetBlue, Pacific Sunwear, and American Eagle are Stock Advisor picks. Microsoft is an Inside Value pick. You can see all of Tom's Hidden Gems picks with your free trial. The Motley Fool has a full disclosure policy.
