2008 has been a painfully volatile year for investors. While this will happen occasionally, it's important to keep in mind the general lessons that tend to work most of the time, and to hang on to those over long periods of time in the stock market.
We're returning to one of those lessons today: Generally speaking, the best-performing stocks of a 10-year period start obscure, ignored, and small.
Small stocks for big returns
From January 1998 through December 2007, 245 stocks on our domestic exchanges could have earned you greater-than-20% annualized returns over those 10 years, turning a $10,000 initial investment into more than $60,000. Of those 245 stocks, 224 of them -- more than 91% -- were small caps 10 years ago. While the companies run the gamut from steelmaker Steel Dynamics (NASDAQ:STLD) to commercial-oven maker Middleby, the common thread is size.
Ten years ago, Steel Dynamics was worth $786 million and Middleby was worth only $82 million. At the beginning of this year, the former was valued at more than $6 billion and the latter at more than $1 billion -- having taken shareholders along for a very rewarding ride.
Though the market's recent downturn has rocked both stocks, Middleby remains on a healthy long-term growth trajectory. The company dominates its niche and has almost every trait investors should look for in a small cap: superior leadership, clear competitive advantages, and impressive and improving returns on equity and assets. Since we recommended it in our Motley Fool Hidden Gems small-cap investing service in 2003, it has returned more than 200% for our members. That number used to be higher, but volatility is a fact of life when it comes to investing in small companies for the long term. But rather than watch returns, we watch the business, to make sure that management is still executing on its stated strategy.
Big stocks for smaller returns
Only 21 mid- or large-cap companies would have given you the same growth; this small group includes Nokia (NYSE:NOK) and EOG Resources (NYSE:EOG). And while the returns have been incredible from these companies -- all of which demonstrated some key traits of great small caps -- they're just not as prevalent as among the small guys.
That's because it's difficult for larger companies to generate the same kind of growth as small caps. While Middleby grew from an $82 million market cap, EOG grew from a $3.3 billion base to be worth nearly $30 billion.
EOG added substantially more value in absolute terms, but the story changes when it comes to stock prices and percentages. Middleby stock returned more than 1,800%; EOG returned about 800%. Now compare that with a much larger company, such as General Electric (NYSE:GE) or Abbott Laboratories (NYSE:ABT). These giants added $131 billion and $36 billion, respectively, to their market caps during the same 10-year span, yet investors earned only 52% and 72%. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.
The Foolish conclusion
In times like these, you as an investor will read a lot about a "flight to quality." That means pulling your money out of small companies and stashing it in megacaps that feel a little bit safer. While every investor should have an overall asset allocation plan that fits his or her timeline, we don't think you should be abandoning small caps today. This remains the one area of the market where individual investors have the opportunity to earn phenomenal returns over long periods of time.
But as this year has proved, there will be pitfalls along the way.
That's why we advocate a diversified portfolio of select small caps for Hidden Gems subscribers. By focusing on factors such as superior management and a strong balance sheet, and enjoying the benefits of diversification, we believe that small-cap investors will not only weather the current downturn, but come out richer on the other side.
If you'd like some help getting started in this incredible area of the market, click here to join our community free for 30 days.
This article was originally published Feb. 6, 2006, as "325 Incredible Returns." It has been updated.
Tim Hanson does not own shares of any company mentioned. Nokia is an Inside Value pick. Middleby is a Hidden Gems selection. No Fool is too cool for disclosure.
