The roller-coaster movement of stocks we've seen in recent months is enough to make anyone queasy. Up 2% one day, down 3% the next -- it's almost enough to make you want to consider Treasury bills.


The CBOE Volatility Index, essentially the market's seismograph, hit 37.50 in August -- its highest level since January 2003. Financial stocks such as Citigroup (NYSE:C), UBS (NYSE:UBS), and Barclays (NYSE:BCS) have been particularly vulnerable to the volatility, as the perceived severity of the subprime and global credit issues ebbs and flows.

Picking on the runts
After four years of market-beating growth, small-cap stocks trail their large-cap peers year to date. This isn't necessarily due to relative valuations, but rather because higher volatility may have nervous investors seeking more stable stocks for their dollars.

In fact, some of the market's best small caps from the past five years have been hit particularly hard: USG (NYSE:USG), Seaboard (AMEX:SEB), and WESCO (NYSE:WCC) are each down more than 20% since July 1.

Investors in these companies have to be wondering whether this is the beginning of a protracted decline, or if it's just some turbulence on the path to long-term outsized gains.

Pop quiz, hotshot
I've been wondering that as well. Back in March, I highlighted a stock that I own, Sun Hydraulics, a then-$250 million hydraulic products company, as a stock that passed the test.

What test, you ask? Well, consider that many of the most successful stocks of our generation all began:

  • Small.
  • Underfollowed.
  • Financially strong.
  • Well managed.
  • Dominant in their market niche.

It's reasonable to assume, then, that the best stocks of the next 10 and 20 years are currently masquerading as small caps with these characteristics.

But back to Sun Hydraulics
Sun Hydraulics surged following its first-quarter earnings report in May and rose 75% in just two months, seeming to validate my investment thesis. Since its peak in July, however, Sun Hydraulics has been rocky to say the least. In the past six weeks, the stock has been rattled back and forth -- down 17% one day, up 20% two days later -- and currently sits more than 16% off its July highs.

The wild ride has almost been enough to make me cash out and enjoy my gains.


Since my investment thesis hasn't changed -- it's still small, underfollowed, financially strong, well-managed, and dominant in its market niche -- I'll be riding out the storm with this one.

Roll with the punches
Volatility is a natural part of the stock market. A recent report issued by The Vanguard Group showed that between 1970 and 2007, the S&P has traded more than 1% in either direction in 24% of trading days in a given year. But investors may have forgotten: In 2005 and 2006, only 12% of the trading days were up or down 1% or more.

Yet, as Vanguard's report reminded investors, "market volatility ... [is] one of the things that help drive equity prices higher over the long run. ... A certain amount of volatility is one of the trade-offs stock investors make in exchange for the expectation of higher long-term returns."

At our Motley Fool Hidden Gems small-cap investing service, we recognize that the great growth potential of small-cap stocks comes with an added dose of volatility. We also believe, however, that by buying shares of great companies at good prices, holding for the long term, and building out our positions during inevitable dips, individual investors can build a fortune investing in small companies.

Led by Fool co-founder Tom Gardner, our Hidden Gems recommendations are beating the market by more than 30 percentage points on average. If you'd like see the stocks we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe.

This article was originally published on Aug. 21, 2007. It has been updated.

Fool contributor Todd Wenning enjoys a good roller coaster now and again, specifically Apollo's Chariot at Busch Gardens Europe. He owns shares of Sun Hydraulics. USG is a Motley Fool Inside Value choice. The Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.