The Next Home Run Stock

I assume that you, like everyone and his Aunt Avis, would love to find the next Microsoft (NASDAQ:MSFT) -- to dig out the market's most precious Hidden Gems. Back in September 1986, Microsoft traded at a split-adjusted price of $0.09 per share. Today, it trades for more than $28. Microsoft has risen more than 315 times in a little more than 20 years, turning a $5,000 investment into nearly $1.6 million.

Of course you'd love to buy the next Microsoft.

But you'd prefer not to take on extreme risk, right?

I think you're smart to think that way. And so does a long list of great money managers -- from Peter Lynch to Seth Klarman, Bill Miller to Charles Royce. They've all searched for small companies with a mixture of sales and free cash flow growth, superior returns on invested capital, heavy insider ownership, and healthy assets -- all at a reasonable price.

Forever great
But remember, companies like Microsoft typically exhibit excellent financials from the day they hit the public markets. Microsoft was never a penny stock (again, that share price of $0.09 back in August 1986 is split-adjusted; the stock traded at $30 back then). Microsoft didn't hype itself in press releases, nor did management make outlandish promises to its investors. It turns out that if you want to find monster long-term winners, you shouldn't throw money at shaky, speculative companies.

Companies like Microsoft are run conservatively by executives who themselves own large positions, including co-founder and chairman Bill Gates. These companies are run to sustain profit growth indefinitely. If you're going to invest in small-cap rocket stocks, as we do together in Motley Fool Hidden Gems, please avoid the whisper-stock party tips and hype jobs. They destroy wealth over time.

Contrary to popular perception, you need not assume great risk to invest in the best small caps. You only need to train yourself to look for disciplined, conservatively run small businesses.

Finding these stocks doesn't involve a hopeless search through barn-sized haystacks for a lone platinum needle. The stock market features plenty of promising smaller companies run successfully by founders with large personal stakes in the enterprise. In fact, they thrive in every industry -- electrical, education, medicine, retail, and beyond. Take a look at these five great investments from 1995 to 2007, all of which were small caps in the mid-'90s.

Note, again, that this group hails from a broad variety of sectors. A few are familiar consumer brands, while the others are to this day largely unknown on Main Street. But each was a small cap 12 years ago. And not only weren't they industry stalwarts, they were also largely unknown to consumers and investors. They had yet to attract a cadre of Wall Street analysts and big institutional investors.

And their stock prices reflected it. They were cheap because they were irrelevant!

They're what we search for together, every day, in Hidden Gems. And these sorts of opportunities do exist today.

The next big thing
The 20- to 700-baggers of the next 12 years are out there right now, with their fuses lit and a wide-open sky above them. But they aren't Cummins. They're also not companies like Microsoft, valued at $270 billion, covered by 41 Wall Street analysts.

They're small companies with strong founders and executive ownership north of 10%. Companies without debt concerns. Companies that generate excess cash from their operations, some of which already pay dividends. Companies that function without any real reliance on Wall Street for financing or table-pounding "strong buy" ratings.

I know it sounds contrary, but I want you to see that many of these small businesses offer low risk and high rewards for their long-term owners. How could a small company be less risky than a giant? Ask the former owners of WorldCom. Not only was that company overfollowed, but it was also fraudulently run!

The exact opposite exists with great small caps. They're well-run and underfollowed on Wall Street, creating price inefficiencies that strongly favor long-term investors.

Does that sound possible? Does it sound logical? It's certainly contrary.

What I look for
Every day in Hidden Gems, we track down the following:

1. Founders with large personal stakes.
2. Financial statements that are easy to read.
3. A solid asset base with little or no debt.
4. Price ratios that significantly undershoot growth rates of free cash flow.
5. Dominant positioning in a profitable niche.
6. Plenty of room to grow.

If you're inclined to think that every small-cap stock is doomed to have a larger competitor stomp it out, I ask you to return to my list of strong performers above. Each rose from obscurity because of sound financial management and shareholder-friendly practices. The free markets gave them plenty of maneuvering room.

But because not every small company is poised for enduring success, I evaluate more than 100 of the 3,000-plus small-cap stocks each month -- all in search of one great Hidden Gems recommendation. As for the others, I find that 90% are too richly valued or too speculative, given the underlying business. That remaining 10%, however, leaves us with hundreds of small caps that will beat the market and dozens that will rise more than 30 times in value over the next 10 to 15 years.

You can read about this, and all of our Hidden Gems recommendations, right now, by signing up for a 30-day free trial. There is no obligation to subscribe. You have my word.

This article was first published on Sept. 24, 2003. It has been updated.

Tom Gardner is co-founder of The Motley Fool, which is investors writing for investors. He owns shares of Microsoft, which is a Motley Fool Inside Value recommendation. Biogen Idec is a Stock Advisor pick. The Fool has a disclosure policy.