Hey buddy, want some personal investment advice?
If you own stocks, you should own small caps. Of course, there's nothing personal about that. It's Wall Street's worst-kept secret. Over the long haul, small-company stocks outperform their mid- and large-cap peers.
You're serious about this
Otherwise, you wouldn't still be reading. You want an edge. So why make this tricky? Everybody knows that investors who make the most money over the long term buy common stocks.
At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who make even more buy small caps, also according to Ibbotson.
The way I see it, we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). Or we can start building a portfolio of our own.
You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I've been at this for a few years, but I also down the occasional cup of joe with Tom Gardner. Tom has made a career out of beating Wall Street to well-run small companies.
And you know what? I'm man enough to admit that Tom and his team at Motley Fool Hidden Gems have led me to a portfolio of small caps I probably wouldn't have found on my own. What's his secret? I think it's that Tom focuses on value, while I love a good story.
Yet for all our differences, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. Smart investors have always looked for:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
I know it's hard to imagine, but these traits gave investors the courage to follow young Scott McNealy into Sun Microsystems
Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those now -- 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. There's a difference. For example, big retailers like Lowe's
Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet Best Buy
You see, there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these hidden gems, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% year after year.
How to get rolling
Back in September 2003, I suggested you take a look at a pair of small-cap ETFs. I'd bought the iShares S&P 600 Growth Index (IJT) at about $65 earlier in the year and was pleased with my returns. I pledged to buy the sister fund, iShares S&P 600 Value Index (IJS).
Despite a little turbulence, the growth fund is up another 72% since. The value fund is also ahead of the broader market. Apparently, the wise guys who pronounced small caps dead back in September 2003 were wrong. (My hunch is that they're still wrong.)
More importantly, these funds trade like stocks, giving you quick and dirty small-cap exposure without having to take the plunge on the stocks of individual companies.
Or how about this?
A lot of folks are testing the waters with low-cost funds like these and then shifting gradually into the stocks Tom tells us about each month in his Hidden Gems newsletter. After all, sooner or later, you probably want to be exposed to at least a few small businesses with big potential.
That's how you beat the market. Meanwhile, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 52%. That's a good bit better than the 29% you'd have if you'd invested in the S&P 500 for the same period. Not bad.
If you want to learn more about how Wall Street's worst-kept secret can help you finally beat the pros, think about this. Tom Gardner's offering a free trial of his complete Hidden Gems service. You can take it up directly with him and sneak a peek at all of his recommendations and print out every one of his back newsletter issues
No pressure. 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. Best Buy is a Stock Advisor and Inside Value pick. Intel is an Inside Value pick. Of course, you can view all Hidden Gems recommendations instantly with your free trial. The Motley Fool has a full disclosure policy.