If you own stocks, you should consider small caps. Of course, that's not personal investment advice. It's Wall Street's worst-kept secret. Over the long haul, small-company stocks outperform mid- and large-caps.
You want an edge
Otherwise, you wouldn't still be reading. So why make this hard? 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 who want to make even more buy small caps, also according to Ibbotson.
Assuming that's true, 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 have the good fortune to down the occasional cup of joe with Tom Gardner. Tom, you may know, co-founded The Motley Fool, but he has made a career out of beating me to well-run small companies.
And I'm man enough to admit that Tom and his crew at Motley Fool Hidden Gems have assembled a portfolio of small caps I probably wouldn't have found on my own. What's their secret? I think it's that Tom's guys focus 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. A long line of smart investors have beat the market looking 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 Larry Ellison into Oracle
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. Harley-Davidson
Or compare Southwest Airlines
Here's one more idea
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet Apple is the only one of the 10 you'll ever hear about from your broker. And that's no coincidence. Though you might very easily recognize Green Mountain Coffee Roasters from "real life."
Put it altogether and you see our edge: We 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 companies, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% year after year.
How to get rolling
Way 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 that year. I pledged to buy the sister fund, iShares S&P 600 Value Index (IJS), next -- a promise I'm glad I kept.
Despite the recent rough patch for smaller stocks, the growth fund is still up 63% since. The value fund is up, too, though not quite as much. More important, 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.
Some more personal advice
Test the waters with these low-cost funds and then shift gradually into the stocks Tom tells you about each month in his Hidden Gems newsletter. Sooner or later, you want to be exposed to at least a few small businesses with big potential -- remember those names I mentioned earlier.
That's where the fun is. 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, 32.2%. That's a good bit better than the 9% you have if you'd invested in the S&P 500. Not bad, right?
If you want to learn more about how Wall Street's worst-kept secret can help you beat the pros, think about this: Look into accepting a no-risk free trial to Tom Gardner's Hidden Gems service. You can sneak a peek at all current and past recommendations, including the analyst team's top five picks for new money right now.
You can even print out every one of his back newsletter issues if you like. Best of all, the first month is on Tom, and there's never any pressure 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. Of course, you can view all Hidden Gems recommendations instantly with your free trial. Apple and Coach are Stock Advisor recommendations. The Motley Fool has a full disclosure policy.