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 track 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 Motley Fool co-founder Tom Gardner -- a guy who has made a pretty decent 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 their focus more on value, while I tend to get wowed by story.
For all that, we do look for many of the same things in a great small company:
- 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 (NASDAQ:CSCO) and even Jeff Bezos into Amazon.com (NASDAQ:AMZN). You had to be nimble to get into that last one ahead of Wall Street, but I don't have to tell you how those investments worked out.
Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least heading into their prime? And you're right. That's why it's so hard to beat the pros with well-known stocks 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 well-known companies. There's a subtle difference.
Consider big retailers like Costco (NASDAQ:COST) and Home Depot (NYSE:HD), for example. They are heavily owned by institutional investors now, but that wasn't always the case. They both had strong regional and even national footprints long before they were closely followed on Wall Street.
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 (NASDAQ:ORCL) or Microsofts (NASDAQ:MSFT). In fact, your broker won't have told you about most of these stocks; though you might easily recognize a company like drink-maker Hansen Natural (NASDAQ:HANS) from "real life" -- just as millions of shoppers recognized Costco and Home Depot.
Of course, that'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 undiscovered gems. That's how he earned his Fidelity Magellan fundholders nearly 30% year after year.
How to get rolling
Way back in September 2003, I first 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 a tough stretch for small caps. In fact, the value fund is up more than 40%. The growth fund is up 50%-plus -- even after the recent pullback.
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, 21%. That's better than the 1% return if you'd invested in the S&P 500 for the same period. You've got to admit that's not half-bad.
If you want to learn more about Wall Street's worst-kept secret and position yourself for the next small-cap rally, Tom Gardner is offering a 30-day free trial to his Hidden Gems service. That way, you can peek at every one of the team's recommendations -- plus the current newsletter and all back issues, including the top five small-cap stocks for new money right 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. The Motley Fool has a full disclosure policy.
