Our goal in Motley Fool Hidden Gems is to find the best small companies to own for the next three to 35 years. It's a wonderful aim, since historical data illustrates that small-cap stocks -- particularly of the value variety -- have substantially outperformed the overall market over the past 40 years.
To optimize our returns, we look to sell our mistakes quickly, hold sound companies for an average of three years, and then, yes, maintain our stakes in the very best of the lot for a quarter of a century or more. The best time to sell shares of a truly superior small company is almost never.
For example, selling SanDisk
It's been more than four years, and the Hidden Gems cumulative returns thus far have easily outpaced the market. Factoring in the recent wipeout, Gems recommendations are down an average of 12%, while equal amounts invested in the S&P 500 over that time would have lost an average of 24%. There's no question that we'll have down periods. But over time, we expect to continue to outperform the general market by buying and holding onto the next wave of great American companies. Prices are low, and we feel strongly this is the time to be buying.
How do we find them?
One way to find the future greats is to carefully study the major winners from the past. Relatively few multi-decade superstars are technology companies. And while we don't avoid tech stocks in Hidden Gems, they're a minority of our selections. Instead, we favor sleepy and underfollowed companies with high-quality management. For the ultimate example, think Wal-Mart.
In November 1980, Wal-Mart was trading at a split- and dividend-adjusted $0.20 per share. That's right, $0.20. But let's be clear: The stock was selling at $50 per share then, so it wasn't ever a penny stock. We think it's nearly impossible to become a penny stock millionaire -- despite the mischievous headline we placed on this article. No, the greatest stocks are those of real companies with real earnings. Because of stock splits, some investors think you'll find the next Wal-Mart while searching among 20-cent stocks. You won't.
So what has Wal-Mart done since 1980 (a full decade after it went public)?
With the stock trading around $56 as of this writing, it has returned 270 times in value over the past 28 years. A $5,000 investment back then is worth some $1.3 million today. That'll clean up a lot of investment mistakes!
But what if we go all the way back to Wal-Mart's IPO, when it became a public company in October 1970? Then the business was valued at a tiny $21.5 million. The company has grown at almost 30% growth per year since, and it would have turned a $5,000 investment into nearly $40 million today.
When the company went public, it raised $4.5 million in cash to pay down debts. Wal-Mart was invisible back then. No one knew about it. Hardly anyone followed it, and more attention was paid to established companies such as Ford
Reverse-engineering a superstar
Now it's time to list the qualities of what has been one of the greatest 25-year investments in the history of our species. Here are the traits of Wal-Mart in its early days, traits that we look for in Hidden Gems:
- After just a few years in the public markets, it began paying a dividend and never stopped -- amazing for such a tiny company. You'll see this in many other great performers over the decades, like Boeing
(NYSE:BA) . - What's more, its dividend started in the teeth of a bear market in the early 1970s. That said a lot about the strength of its financials.
- Wall Street treated the company like it was a bunch of Arkansas hillbillies. For years, no analysts followed it.
- For years and years, institutional ownership was well below 50%. As we said, hardly anyone cared.
- Sam Walton owned the majority of the stock. Here was a founder with a stake in the organization's enduring success.
- Its concept was new and innovative, yet proven. Wal-Mart had been in business for eight years before going public, with more than 30 stores and more than $32 million in sales on the day of its IPO.
- It had a compelling valuation, trading at just 0.67 times sales when it came public.
Find the next one
We're not trying to reinvent the wheel here at Hidden Gems because we simply don't need to. There's something on the order of 100 years of researchable history of the U.S. stock markets, and tons of data available over the past 25 years. The Internet makes much of the research relatively quick and easy.
There are also many masters who have shared fully formed ideas on how to earn extraordinary returns in small caps -- from Peter Lynch to Charles Royce to Warren Buffett to Martin Whitman. By combining our research capabilities with the outstanding principles these folks have handed down, we can do a lot together to increase your wealth over the long term.
That's is the aim of our Hidden Gems community every day, with thousands of members working together and examining the more than 7,000 public companies capitalized at less than $2 billion. We see the early outperformance in the long-term charts for Amazon.com
If you'd like full access to our service for a trial run of 30 days, let us know. It's free, and there's no obligation to subscribe.
This article was originally published on Dec. 17, 2004. It has been updated.
Rex Moore is a Stock Advisor analyst and contributes the Foolish 8 screens to Hidden Gems. He owns shares of Qualcomm. Wal-Mart is an Inside Value recommendation. Amazon is a Stock Advisor pick. The Motley Fool is investors writing for investors.
