Remember the bull market? When you and your buds used to swap stories about how some guy lived next door to Larry Ellison, bought the Oracle (NASDAQ:ORCL) IPO in 1986, and retired at 30?
Good times. Back in my old man's day, it was a poker pal of old Walt who made a killing buying Disney (NYSE:DIS). That might seem a bit out of step with the times right now, but you have to admit it's a great story.
But be careful. That sword cuts both ways. After all, what about the less-fortunate chumps who get wiped out when their hot stock tip goes belly up? Isn't that the "problem" with buying lesser-known companies, after all? That they're a crapshoot?
You're smart to think that way
Go to Harvard Business School, and you'll hear the same thing. Just be sure to pack a few hundred grand. Or save yourself a few bucks and consider this. What if the problem isn't with small-cap companies at all, but with us -- small-cap investors?
What if small caps just attract a bad crowd? What if it's those gamblers and daredevils (and nosy neighbors) vying for the next home run stock that creates an "illusion" of a wacky and treacherous market?
Don't take my word for it -- there's plenty of data to support that contention. But there's something more important than any piece of data -- how you can use this "illusion" to make money.
Why small-cap investors get creamed
Any finance professor can tell you why small caps are risky. Markets are illiquid. Earnings are lumpy and less dependable. Capital is costly and hard to get, especially when times get tough.
Still, I'm not convinced that's why small-cap investors get pummeled. It's more insidious than that. It's because, too often, they don't invest. They speculate on stock tips and story stocks with low-quality -- or worse, no -- real earnings.
Small-cap investors -- too many of them, at least -- ignore business fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small-company stock at a party or on TV, and he wasn't focused entirely on the story? Hardly ever, right?
Then again, who wants a cigar butt?
Now, compare that with the stodgy old-timers who focus on mature large-cap, cigar-butt, and smokestack companies trading at bargain-basement prices. Could these guys be more boring? They never talk story. They're all assets, cash flows, and valuation.
Sure, you could have made money on a neglected blue chip like Coca-Cola the last few years. I did myself. Or by pulling the trigger on General Electric (NYSE:GE) or Goldman Sachs (NYSE:GS) right now. But even best-case, their triples and quadruples are behind them. They're just too big.
But what if we could take the old-school valuation techniques made famous by Ben Graham and Warren Buffett and apply them to up-and-coming smaller companies while their growth spurts are still ahead? Again, I know it sounds simple, but you'd be amazed at how few investors even try.
Forget "the next home run stock"
If you're a regular here, you know that I've been tracking my colleague Bill Mann's progress at Motley Fool Hidden Gems. Along with folks like Chuck Royce and David Nierenberg (whom we had the pleasure of meeting here at Fool HQ recently), Bill and his team are among the few folks I've seen who are still taking advantage of this little "trick."
The trick, of course, is shunning "the next big thing" and buying small businesses with strong fundamentals at good prices -- in other words, small-cap value stocks. The guys I just mentioned make money in small caps by balancing "story" and "potential" with fundamentals and valuation.
In the 1980s, this kind of thinking led investors to Home Depot (NYSE:HD). Before that it was Wal-Mart (NYSE:WMT) that helped patient investors turn a modest $5,000 investment into millions. But how did they find it? I mean, what exactly was so great about Sam Walton's general store back in 1975?
Earnings, earnings, earnings
In 1975, Wal-Mart was rapidly expanding revenues and profits. That's not the case with too many of today's hot stock tips. In some cases, "story stock" companies you read about in the tip sheets may be growing sales, but too often they don't actually have earnings at all.
Which isn't to say they don't have potential. But they are all "potential." You need only check the day's biggest percentage winners to see what I mean. Today it was medical device maker Mentor (NYSE:MNT), up nearly 90% on news that Johnson & Johnson will buy the company for $1.07 billion.
But remember, that sword cuts both ways.
Speculating on companies like these may work out for you, but it's going to be a wild ride. The safer play is to dig up small caps like Wal-Mart -- only when they're still small -- that can make you a lot of money methodically over the years.
This "trick" turned $1,000 into $33 million
Granted, it took 80 years to do it, but according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.
That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large-company stocks instead. Will those numbers hold up?
Nobody can say for certain, but I have a hunch they will. History has a habit of repeating itself, and it's almost never different this time.
How about some good news?
You don't have to pay Harvard to find great small-cap values anymore. You can pick up Ben Graham's classic Security Analysis. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- and there's no heavy reading required.
You can join my pal Bill Mann and his team at Motley Fool Hidden Gems free for 30 days. This way, you can check out the complete service, including every recommendation and every back issue. You even get the team's top five picks for new money right now. Check them out for free right now, then take a whole month to decide whether you want to join.
If nothing else, you'll meet a lot of supportive and knowledgeable investors who love to talk stocks, and nobody will pressure you to subscribe. In other words, the first lesson is on me. To take advantage of this special free trial, click here.
This article was originally published on Feb. 17, 2006. It has been updated.
Fool writer Paul Elliott promises to keep you posted on the team's progress at Hidden Gems (yes, through good times and bad). You can view all Hidden Gems picks on the scorecard with your free trial. Paul owns shares of Coca-Cola, which is a Motley Fool Inside Value pick, as are Wal-Mart and Home Depot. Disney is a Stock Advisor recommendation. Johnson & Johnson is an Income Investor choice. The Motley Fool has a disclosure policy.
