Heard the one about the cowboy from San Jose who bet the ranch on Adobe (NASDAQ:ADBE) in 1990 and retired 10 years later? It's the oldest story ever told. In my father's day, it was upstate New York, and the lucky devil bought IBM (NYSE:IBM).

Either way, it's a good story. But that sword cuts both ways, right? What about us chumps who get wiped out when our hot stock tip suddenly goes belly-up?

Isn't that the "problem" with buying lesser-known companies, after all? That they're a crapshoot?

Well, you're smart to think that way
Go to Harvard Business School, and they'll tell you the same thing. Be sure to pack a few hundred grand in small bills, though. Or save yourself some money and consider something else.

What if the problem isn't with small-cap stocks, but with small-cap investors?

What if the problem with small caps is that they attract the wrong crowd? Maybe it's all those gamblers and daredevils, vying for the next home run, who create an "illusion" of a wacky and treacherous market.

Don't take my word for it -- reams of data support that contention. But there's something more important than any piece of data -- how you can use this "illusion" to make money.

Why small-cap investors get creamed
Anybody can tell you why small caps are risky. Markets for their stocks are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to secure, especially when times get tough.

All true, but I'm not convinced that's why small-cap investors get pummeled. It's more insidious than that. It's because they don't invest. Small-cap investors speculate on stock tips and high-risk story stocks with low-quality -- or worse -- no real earnings. It's that simple.

Small-cap investors -- too many of them, at least-- ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small-company stock at a party or on TV, and he wasn't focused entirely on the story? Hardly ever, right?

Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who focus on mature large-cap, cigar-butt-and-smokestack companies trading at bargain prices. Could these guys be more boring? They never talk story. They're all assets, cash flows, and valuation.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. You can make money on fallen angels like Pfizer (NYSE:PFE) -- I own it myself -- or cash-heavy megacaps like Johnson & Johnson (NYSE:JNJ), but their triples and quadruples are behind them. They're just too big.

The Holy Grail, obviously, would be to apply Warren Buffett's old-school valuation techniques to up-and-coming smaller companies, while their growth spurts still lie ahead. Again, I know it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget "the next home run stock"
If you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with folks like Chuck Royce and David Nierenberg, Tom and his crew over at Motley Fool Hidden Gems are among the folks I've seen cashing in on this little "trick."

The trick, of course, is buying small businesses with strong fundamentals at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing "story" and "potential" with fundamentals and valuation.

That's what led investors to Wal-Mart in the '70s. They turned a $5,000 investment into $2.5 million. But what exactly was so great about Sam Walton's general store back in 1975? Take a look at how Wal-Mart compared with some of today's whisper-stock party tips:




Sales CAGR

Earnings CAGR

Wal-Mart (1975)





Dendreon (NASDAQ:DNDN)





Conexant Systems (NASDAQ:CNXT)










*Revenue and income data are TTM and in millions. Data courtesy of Capital IQ, a division of Standard & Poor's. Wal-Mart data courtesy of company filings.

Clearly, while Wal-Mart delivered rapidly expanding revenue and profits back in 1975, that's not the case at the other companies in the table. In some cases, revenues are picking up, but all the other firms are struggling to grow earnings.

You can see how stocks like these are mostly "potential." The fact is that speculating on these stocks may work out for you, but it may not. The safer play is to dig up small caps like Wal-Mart -- when they're still small caps -- that can make you a lot of money methodically over the years.

After all, this "trick" turned $1,000 into $33 million
Granted, it took nearly 70 years to do it, but still ... according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large caps instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for just about four years now, but judge for yourself.

So far, Tom has alerted his subscribers to dozens of small-cap value stocks. More than a dozen subsequently doubled or more, and as of this morning, the entire portfolio is up 49.7% on average. That's compared with 19.4% if you'd bought the S&P 500 instead.

How about some really good news? 
You don't have to pay Harvard to find great small-cap values. You can get Ben Graham's Security Analysis at the library ... if you're up for flipping through 700 pages, that is. But there may be an easier way -- and there's no speculation required.

You can join Tom Gardner at Hidden Gems free for 30 days. You can check out the complete service online for a full month, including all of Tom's recommendations, his top five picks for new money now, and every back issue. Then take a whole month to decide whether you want to join.

I guarantee you'll meet lots of friendly and knowledgeable folks, and there will be no pressure to subscribe. Best of all, the first lesson is always on Tom. To learn more about this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all of Tom's picks on his scorecard with your free trial. Paul owns shares of Pfizer, an Inside Value recommendation. Wal-Mart is also an Inside Value pick. Johnson & Johnson is an Income Investor selection. The Motley Fool has a disclosure policy.