Where were you 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 like this one. And looking back, I may have stumbled on two small ideas that could have made us both some money.
You may still have time
In case you weren't with us back then, here they are ...
- The rally in small-company stocks may still have legs.
- If you don't invest in small companies, don't assume you're covered by your mutual funds. Not even so-called "total market" funds.
I think both still apply. I'll tell you why, but first, let's go back to September 2003, when a lot of "experts" were calling an end to the small-cap rally. I didn't buy it then (and I hope you didn't, either).
Instead, I suggested that you take a look at iShares S&P SmallCap 600 Growth (IJT). If you did, you're up some 80%. And that's on a diversified index of stocks despite the long-predicted rotation into big caps. Well done.
Why you should keep it small
I won't rehash my entire argument here, but one point is worth noting. In September 2003, I wasn't convinced we had made up the ground we'd lost during our 1990s love affair with megacap stocks. I'm still not.
After all, we catch some grief around here for constantly pointing out how difficult it would be for massive operations like IBM (NYSE:IBM) or Hewlett-Packard to double their nearly $100 billion in revenues. But it's true -- and that's not even the worst of it.
After all, even if these guys make all the right moves, we still might not see the glory days of the '90s again. In fact, you can point to any number of large-cap stalwarts whose revenues and earnings have been solid, yet the stocks have failed to keep pace since we had this chat back in 2003. That's what I call a painful morning after.
But we're just getting buzzed
Plus, even if I am all wrong about small caps right now, it's not the end of the world. In my view, the advantages of small companies extend beyond short-term cycles and relative valuations. Small companies are simply more agile and better poised for growth than the behemoths we hold in our total market index funds.
That's why I'm a fan of Tom Gardner's Motley Fool Hidden Gems approach. For one thing, Tom invests from the bottom up. When you focus on specific bussinesses, you don't need strength in a sector, cap size, or investment style. And when you focus on small companies, you get another bonus -- if you know how to play it.
There's less known about 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.
Now, the problem with your mutual funds
Don't assume you're covered by your stock index 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 of $188 billion Johnson & Johnson (NYSE:JNJ) than $20 billion Boston Scientific (NYSE:BSX).
And while you may think you own equal chunks of 3,650 stocks, you don't. Even a so-called total market fund gives you much more exposure to, say, the $150 billion JPMorgan Chase (NYSE:JPM) -- and financial stocks in general -- than you may think. As for No. 3,650 (whatever that is), you barely have any.
In fact, just 10 massive stocks make up more than 16% of your "total market" portfolio. That's why a one-day sell-off in a big pharma like Merck (NYSE:MRK), or any one of the major banks or energy stocks, sends you running for the Alka-Seltzer, while today's 40% pop in tiny China BAK Battery (NASDAQ:CBAK) barely buys you lunch.
Famous last words
Finally, even if you agree that megacaps are due, you still should own small stocks. History proves that many (if not all) of tomorrow's Goliaths are Davids right now. And unlike with the behemoths we've discussed, an extra $1 billion in earnings at any one of these companies can make you a whole lot richer.
If that sounds good to you, I recommend giving Hidden Gems a try. Tom and his team of analysts have already turned up two dozen stocks that doubled in value or more, including one 500%-plus gainer. Tom has me convinced that his next 10-bagger is sitting on his buy list right now.
So, if you're looking to beat the market silly, that's where I'd start. You can check out every one of Tom's picks the instant you start your trial (you can even print out the scorecard and all the back issues). If you're not impressed by what you see, simply don't subscribe ... and don't pay. To find out more about taking a free trial, click here.
This article was originally published March 24, 2006. It has been updated.
Fool contributor Paul Elliott promises to keep you posted on the progress at Motley Fool Hidden Gems. As of this morning, the picks are up 59.4%, versus 24.3% if you'd bought the S&P 500 instead. You can view them all on our scorecard with your free trial. Paul owns the iShares S&P SmallCap 600 Growth ETF. Johnson & Johnson and JPMorgan are Income Investor picks. The Motley Fool has a disclosure policy.
