Want some personal investment advice?
If you own stocks, you should own small caps.
Wait, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you money.
You're serious about this
You want an edge. We all do. So why make this difficult? Everybody knows that investors who make the most money over the long term buy and hold common stocks.
At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors looking to goose their returns even more own small caps, also according to Ibbotson.
The way I see it, we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy a small-cap exchange-traded fund (ETF) or two. 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. Well, sort of. You see, I have the occasional cup of joe with Fool co-founder Tom Gardner -- a guy who has made a career out of beating Wall Street to profits on well-run small companies.
And you know what? I can admit that Tom and his research team at Motley Fool Hidden Gems are assembling a portfolio of small caps I probably couldn't find on my own. What's their secret? I think it's that they focus on value, while I tend to get wowed by story.
For all that, we really do look for many of the same things in a great small company. And, truth be told, it's not like either one of us invented this approach. Generations of smart investors have 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 green light to follow John Morgridge into Cisco Systems
Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like that -- at least in their prime? And you're right. That's why it's so hard to beat the pros with familiar names like those now -- if they're really all that, they're going to cost you.
But 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 necessarily well-known companies. There's a difference.
Consider big retailers like Costco
Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. Just don't expect a bunch of Oracles
Of course, right there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these gems. That's how he earned his Fidelity Magellan 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 SmallCap 600 Growth Index (IJT) at about $65 earlier in the year and had done well. I pledged to buy the sister fund, iShares S&P SmallCap 600 Value Index (IJS), next.
You probably think I got murdered, right? After all, it's been tough year or so for small caps. In fact, both funds are still up some 50% since -- even after the second-chance buying opportunity we've been given.
Best of all, both funds trade like stocks, giving you quick and dirty small-cap exposure without the stress of taking the plunge on the stocks of individual companies.
What to do now
If you ask me, a strategy of holding these funds and scaling into the stocks Tom tells you about each month in his Hidden Gems newsletter is a winner. After all, diversification is nice, but sooner or later, you want to own a few small businesses with home run potential.
Meanwhile, 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, 28.4%. That's better than the 8.7% return if you'd invested in the S&P 500 for the same period. You've got to admit that's pretty good.
If you want to learn more about Wall Street's worst-kept secret, Tom is offering a 30-day free trial to his Hidden Gems service. That way, you can peek at every one of his recommendations -- plus the current newsletter and all back issues. You even get his top five picks for new money now. Best of all, 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 SmallCap 600 Growth Index and the iShares S&P SmallCap 600 Value Index, but no other securities mentioned in this article. Amazon.com and Costco are Stock Advisor picks. Home Depot and Microsoft are Inside Value picks. You can view all of Tom Gardner's Hidden Gems picks with your free trial. The Motley Fool has a full disclosure policy.