This Could Be the Next Multibagger

Prevailing wisdom says that, with the bear's return, we're doomed to years of losses. Hogwash. Multibaggers are still out there.

They won't be easy to find, of course. During the dot-com bust, 60% of companies worth at least $250 million in market value and trading on U.S. exchanges realized negative returns between March 2000 and October 2002.

Tiny doublers
That's the bad news. The good? Forty percent earned positive returns and, of those, 119 stocks at least doubled. Roughly a third of them were multibaggers, thanks in part to their excellent balance sheets. Here are the top five performers:

Sources: Capital IQ, Yahoo! Finance.

Two things stand out when I look at this data:

1. All of the top stocks were small caps.
2. Industry didn't matter. The top three were a retailer, a miner, and an educator.

So what did matter? Management.

For example, executives at Chico's FAS produced greater-than-30% returns on invested capital in three of the four quarters leading up to the beginning of the bust in April 2000. And then, in the very next quarter, as the tech bubble popped, Chico's ROIC improved to -- get this -- 47%.

While Chico's was busy improving its business and ignoring the macroeconomic climate, investors were rewarded with a multibagger.

Kick the recession before it kicks you
Your strategy, then, should be to find stocks whose businesses are improving even as the economy worsens. You should want:

1. A meager market cap.
2. A minimal Wall Street following.
3. An excellent balance sheet.
4. High and improving returns on invested capital.

Most of these attributes are obvious. Who wouldn't want to be invested in firms with excellent balance sheets when overleveraged banks and brokers are going bust? Count me among the conservatives on this issue.

But what about ROIC? Is it really as important as it seems? Yes and here's why: Excess growth is a byproduct of efficient capital deployment. Excess returns are a byproduct of excess growth.

Think of a new plant that produces expensive, in-demand widgets at a lower cost. Allocating cash flow in this way should increase margins. Higher margins should improve earnings and cash flow and, thereby, increase the company's market value.

Call it a financial game of connect-the-dots. Managers who play really well tend to generate big gains for their shareholders.

A small cap to buy now
But the game is harder today than it has been in years. Reduced consumer spending and tighter lending standards mean that capital is harder to come by. The pressure to produce excess returns and extend growth is higher.

Even now, though, some companies appear to be up to the task. Cash hoarders Cisco (NASDAQ:CSCO) and ExxonMobil (NYSE:XOM) get the nod from analysts.

Trouble is, these are large caps, and history says you should go small. Which tiny titan to choose? I prefer children's retailer Gymboree (NASDAQ:GYMB). Here's why:

Sources: Capital IQ, Yahoo! Finance.

Even though second-quarter revenue grew less than 13% year over year, net income jumped by 38%. That's telling; it suggests that management is effectively pulling the levers of economic value. And yet the stock trades for roughly 9 times earnings -- very reasonable for a cash-rich grower.

But this is just one stock; dozens of good ideas are out there. You'll find many of them -- the tiny titans in the making -- in our Motley Fool Hidden Gems portfolio, which is beating the market by more than 12 percentage points as I write.

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Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Coventry Health Care is a Motley Fool Stock Advisor selection. The Motley Fool's disclosure policy was a small-time stock operator before it went big time.