Ever hear the one about Larry Ellison's nosy neighbor in Berkeley? The guy who bought Oracle (Nasdaq: ORCL) in 1986, then dumped the stock 15 years later and retired?
Back in my old man's day, it was a poker pal of old Walt who made a killing buying Disney (NYSE: DIS). Either way, it's a great story.
But that sword cuts both ways, right? What about the less-fortunate chumps who get wiped out when their hot stock tip goes belly up? Isn't that the "problem" with buying lesser-known companies, after all? That they're a crapshoot?
You're smart to think that way
Go to Harvard Business School, and you'll hear the same thing. Just be sure to pack a few hundred grand in small bills. Or save yourself a few bucks and consider this. What if the problem isn't with small-cap companies at all, but with us -- small-cap investors?
What if small caps just attract a bad crowd? What if it's 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. Earnings are lumpy and less dependable. Capital is costly and hard to get, especially when times get tough.
Still, I'm not convinced that's why small-cap investors get pummeled. It's more insidious than that. It's because, too often, they don't invest. They speculate on stock tips and story stocks with low-quality -- or worse, no -- real earnings.
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.
Sure, you could have made money on a neglected blue chip like Coca-Cola (NYSE: KO) the last few years. 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 just too big.
But what if we could 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 try.
Forget "the next home run stock"
If you're a regular here, you know that I've been tracking Motley Fool co-founder Tom Gardner's progress at Motley Fool Hidden Gems with great interest. Along with folks like Chuck Royce and David Nierenberg (whom we had the pleasure of meeting here at Fool HQ recently), Tom and his team are among the few 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 stocks. The guys I just mentioned 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 they are all "potential." You need only check the day's biggest percentage winners to see what I mean. Today it was tiny health-care player MEDecision (Nasdaq: MEDE) up nearly 300% on news that it was being acquired.
Tomorrow, it'll be someone else -- but remember, that sword cuts both ways. Speculating on companies like these may work out for you, but it's a wild ride. 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 better than five years now.
Already, more than a dozen Hidden Gems recommendations subsequently doubled in value or more, and as of this morning, the entire portfolio is up 29.6% on average. That's better than three times the 7.5% you'd have earned on the S&P 500 -- 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. 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 service, including every recommendation and every back issue. You even get the team's top five picks for new money right now. Check them out right now, then take a whole month to decide whether you want to join.
If nothing else, 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 me. 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. The Motley Fool has a disclosure policy.
