Have you ever heard the one about Larry Ellison's nosy neighbor in Berkeley who bet the ranch on Oracle (Nasdaq: ORCL) in 1986, sold the stock 15 years later and retired?
It's the oldest story ever told. Back in the day, it was a poker pal of old Walt who made a killing on Disney. However you tell it, it's a great story.
But that sword cuts both ways, right? What about us less-fortunate chumps who get wiped out when our hot stock tip suddenly goes belly-up, leaving us holding the bag? 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 companies, but with small-cap investors?
What if the problem with small caps is that they attract a bad crowd? Maybe it's all those gamblers and daredevils (and nosy neighbors) vying for the next home run stock that creates an "illusion" of a wacky and treacherous market.
Don't take my word for it -- there's plenty of data to 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
Any finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to get, 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. They 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 business 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-basement 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. Sure, you could have made money on a neglected blue chip like Coca-Cola (NYSE: KO) last year -- I did myself -- or by rolling the dice on a General Motors (NYSE: GM) or Washington Mutual (NYSE: WM) comeback right now. But even best-case, their triples and quadruples are behind them. They're still too big.
The Holy Grail, obviously, would be to take the old-school valuation techniques made famous by Ben Graham and Warren Buffett and apply them to up-and-coming smaller companies while their growth spurts are still 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 (who we had the pleasure of meeting here at Fool HQ recently) 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 shunning "the next big thing" and buying small businesses with strong fundamentals at good prices -- in other words, small-cap value. The guys I just mentioned consistently make money in small caps by balancing "story" and "potential" with fundamentals and valuation.
In the 1980s, this kind of thinking led investors to Home Depot (NYSE: HD). Before that it was Wal-Mart that helped patient investors turn a modest $5,000 investment into millions. But how did they find it? I mean, what exactly was so great about Sam Walton's general store back in 1975?
Earnings, earnings, earnings
In 1975, Wal-Mart was rapidly expanding revenues and profits. That's not the case with too many of today's hot stock tips. In some cases, "story stock" companies you read about in the tip sheets may be growing sales, but too often they don't actually have earnings at all.
Which isn't to say they don't have potential. But you can see how they are all "potential." You need only check the day's biggest percentage losers to see what I mean. Yesterday it was Northstar Neuroscience (Nasdaq: NSTR) investors who got clobbered when the company's cortical stimulation device failed to restore hand and arm function in stroke victims.
Today, it'll be someone else. Speculating on companies like these may work out for you, but it's a crapshoot. The safer play is to dig up small caps like Wal-Mart -- when they're still small -- that can make you a lot of money methodically over the years.
This "trick" turned $1,000 into $33 million
Granted, it took 80 years to do it, but 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-company stocks instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for only a couple of years now, but judge for yourself.
So far, Tom has alerted his subscribers to more than 50 small-cap value opportunities. Nearly a dozen subsequently doubled or more, and as of this morning, the entire portfolio is up 19.7% on average. That's compared with just 3.3% if you'd bought the S&P 500 instead -- during a very tough market indeed.
How about some really good news?
You don't have to pay Harvard to find great small-cap values anymore. You can pick up Ben Graham's classic Security Analysis on Amazon. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- and there's no heavy reading required.
You can join Tom Gardner at Motley Fool Hidden Gems free for 30 days. This way, you can check out the complete Hidden Gems service, including all of Tom's recommendations and every back issue. You even get his top five picks for new money right now. Check them out. Then take a whole month to decide whether you want to join.
I guarantee you'll meet lots of supportive and knowledgeable investors who love to talk stocks, and nobody will pressure you to subscribe. In other words, the first lesson is on Tom. To take advantage of 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 Hidden Gems picks on his scorecard with your free trial. Paul owns shares of Coca-Cola, which is a Motley Fool Inside Value pick, as are Wal-Mart and Home Depot. Disney is a Stock Advisor recommendation. Washington Mutual is an Income Investor pick. The Motley Fool has a disclosure policy.
