The Stocks You Should Own

We senior analysts here have a terrible habit of landing ourselves on the opposite side of the table from our boss, Motley Fool CEO and co-founder Tom Gardner.

Tom recently asked several of us to present him with a batch of stock ideas. We proceeded to spend the next week furiously burrowing through piles of quarterly reports, conference-call transcripts, and Fool articles. The result? We produced a small list of well-known, undervalued large caps.

After making a pitch for one of these slow-growing behemoths, Tom asked us a deceptively difficult question: "Say this stock moves up to your estimate of intrinsic value next quarter. What then?"

Though a seemingly simple question, like most of Tom's probing queries, his point centered on an underlying investing lesson.

What we had overlooked
Tom's unspoken point was that sustainable, market-smashing returns are not earned by simply riding large, undervalued stocks back to their fair value. Rather, long-run outperformance is best achieved by investing in growing, well-run companies that consistently increase shareholder value.  

The question then becomes where to find such promising companies. For individual investors like you and us, our best shot at thoroughly beating the market is with small-cap stocks.

Before you say it's too risky ...
When it comes to small-cap stocks, we as individual investors have many advantages over Wall Street. One reason is that Wall Street focuses on large-cap stocks because they naturally attract more investor (read: institutional investor) interest, and there's thus greater demand for Wall Street's research.

While the wingtip-wearers upgrade and downgrade the same large stocks over and over again to the delight of their customers, they're simultaneously ignoring promising stocks -- small caps -- that their customers don't care to know about.

Right under our noses
Though these are the stocks you should own, some will argue that it's impossible to spot big winners while they're small. We think that's rubbish.

Consider that one of the best-performing stocks of the past 10 years, Green Mountain Coffee Roasters, shared traits with past small-cap winners such as Wal-Mart and Dell. Each had:

1. Dedicated founders with large personal stakes.
2. A solid asset base with little or no debt.
3. Dominant positioning in a profitable niche.
4. Plenty of room to grow.

By limiting our search to small caps that fall into these categories, we can improve our chances of finding big winners. The alternative, of course, is to go head-to-head with the throngs of Wall Street analysts who are all vying to find the best large-cap opportunities, where the potential rewards are a bit lackluster.

For example, here are a handful of the top-performing large caps since August 1998:

Source: Capital IQ, a division of Standard & Poor's.

Sure, these returns aren't too shabby, but they pale in comparison with the 3,500% return that Green Mountain Coffee posted over the same period. For those of you playing at home, a $1,000 investment in Green Mountain in July 1998 would be worth more than $36,500 today.

Lost in the desert on a horse with no name
For individual investors without a team of Wall Street analysts doing research for them, the prospect of digging around the financial statements of small-cap stocks may seem futile. It's not. It just takes an extra pinch of effort to uncover these potential winners and a splash of patience to let them grow.

If you need some help getting started on this adventure, our Motley Fool Hidden Gems small-cap team is here to help. The analysts look for promising small stocks that share the same qualities as those we discussed above. Taking that approach led them to commercial-oven maker Middleby in 2003. In Middleby, they saw a growing $170 million business with nearly 50% insider ownership, free cash flow generation, and a solid balance sheet. Middleby shares have since gained nearly 450% for Hidden Gems subscribers.

If you'd like to see the rest of the Hidden Gems picks, a free 30-day trial to the service is yours. Just click here to get started.

This article was first published May 1, 2008. It has been updated.

Joe does not own shares of any company mentioned, but Todd owns shares of Procter & Gamble. Wal-Mart and Dell are Motley Fool Inside Value recommendations. Middleby is a Hidden Gems selection. The Motley Fool has a disclosure policy.