We all want an edge. So why make things difficult? Investors who make more money over the long term buy common stocks.
At least, they have since Ibbotson Associates started keeping tabs in 1926. Investors who want to make even more buy small-company stocks, also according to Ibbotson.
The way I see it, we have a few choices. We can roll the dice on a small-cap mutual fund -- if we can find one that's open. We can buy a small-cap exchange-traded fund (ETF) -- more on that later. Or we can start building a small-cap portfolio of our own.
You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Sort of. You see, I recently had the pleasure of chatting with Motley Fool founder Tom Gardner -- an unusual investor who makes a good living buying well-run small companies ahead of Wall Street.
And you know what? I'm beginning to suspect that Tom and his team of analysts at Motley Fool Hidden Gems are on to something -- that Tom really is assembling a portfolio of small companies I wouldn't have found on my own. What's their secret?
I think it's that Tom focuses more on fundamentals, while I tend to get wowed by story. More specifically, Tom adheres to a checklist of important criteria when searching for great small companies:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
Good work if you can get it
Of course, who wouldn't want a portfolio filled with stocks like that? Good point. That's precisely the problem with trying to beat the pros with well-known, large-cap names -- if they're really all that, they're going to cost you.
So, 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. Compare Google
What about teen retailers Abercrombie & Fitch
There's always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Peter Lynch was a master at finding these stealth bombers. Remember, it was low-tech retailers like Gap
You can do it, too
To prove it, Tim Hanson tracked down the best-performing stocks of the past 10 years. Check them out. But don't expect to find story stocks and Wall Street regulars on the list. Instead, look for solid businesses that started as underfollowed stocks. Mid-tier biotech Celgene
I hope you can see how this is great news for investors like us. It proves we can find established, profitable companies with unknown stocks and ride them to big profits. Some you will have heard of; others you may not have -- yet. Some even dominate their markets.
As for relying on the next Peter Lynch, a word of warning: Outperforming with a mutual fund is a crapshoot at best. That's why I like exchange-traded funds (ETFs) -- you get broad exposure to an entire group (like small caps) without the management fees associated with typical funds. I've personally done well with both the iShares S&P 600 Small-Cap Growth (IJT) and Value (IJS) indexes.
What to do now
If you ask me, a strategy of holding these ETFs and scaling gradually into the stocks Tom tells you about each month in his Hidden Gems small-cap newsletter is a winner. After all, you want to be diversified, but sooner or later, you also want exposure to a few small businesses with massive potential.
Meanwhile, to prove I'm no fair-weather fan, I promise to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 50%. That's compared with 20% if you'd invested in the S&P 500 for the same period. That's a serious edge.
If you're interested, you can get a free trial of the complete Hidden Gems service. That way, you can take up Wall Street's worst-kept secret directly with Tom and check out every current and past recommendation (including Tom's top five picks for new money now). You can even check out all back issues online for an entire month. Of course, 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. Gap, Yahoo!, and American Eagle are Stock Advisor picks. Gap and Wal-Mart are Inside Value picks. You can view all of Tom Gardner's Hidden Gems picks instantly with your free trial. The Motley Fool owns stock in American Eagle. The Motley Fool has a full disclosure policy.