The Next Home Run Stock

I assume that you, like everyone and his Aunt Audrey, would love to find the next Wal-Mart (NYSE: WMT) -- to dig out the market's most precious small companies. Back in October 1977, Wal-Mart traded at a split- and dividend-adjusted price of $0.05 per share. Today, it trades for around $56. In a little more than 30 years, Wal-Mart has turned a $5,000 investment into more than $5 million.

Of course you'd love to buy the next Wal-Mart.

But you'd prefer not to take on extreme risk, right?

I think you're smart to think that way. So do a host of great money managers -- from Peter Lynch to Seth Klarman, Bill Miller to Charles Royce. They've all searched for small companies with a mixture of sales and free cash flow growth, superior returns on invested capital, heavy insider ownership, and healthy assets -- all at a reasonable price.

Image source: Getty Images.

Forever great
But remember, companies like Wal-Mart typically exhibit excellent financials from the day they hit the public markets. Wal-Mart was never a penny stock (again, that share price of $0.05 back in October 1977 is split- and dividend-adjusted; the stock traded at $17 back then).

Wal-Mart didn't hype itself in press releases, nor did management make outlandish promises to its investors. As it turns out, if you want to find monster long-term winners, you shouldn't throw money at shaky, speculative companies.

Wal-Mart founder Sam Walton, who owned a massive stake in the enterprise, ran his company conservatively for decades. And just four years after its IPO as a tiny public company, Wal-Mart began paying a dividend. This business was run to sustain yearly profit growth indefinitely.

If you're going to invest in small-cap rocket stocks, as our team does at Motley Fool Hidden Gems, please avoid the whisper-stock party tips and hype jobs. They destroy wealth over time. Wal-Mart wasn't getting hyped. No one was following it!

Contrary to popular perception, you need not assume great risk to invest in the best small caps. You only need to train yourself to look for disciplined, conservatively run small businesses.

Finding these stocks doesn't involve a hopeless search through barn-sized haystacks for a lone platinum needle. The stock market features plenty of promising smaller companies, run successfully by founders with large personal stakes in the enterprise.

In fact, they thrive in every industry -- electrical, education, medicine, retail, and beyond. Take a look at these six great investments from 1996 to 2008, all of which were small caps in the mid-'90s.

All prices adjusted for splits and dividends. Data from Yahoo! Finance.

Note, again, that this group hails from a broad variety of sectors. A few are familiar faces, while the others remain largely unknown on Main Street. But each was a small cap 12 years ago. And not only were they not industry stalwarts, but they were also flying below most consumers' and investors' radar. They had yet to attract a cadre of Wall Street analysts and big institutional investors.

Their stock prices reflected it. They were cheap because they were irrelevant! And these sorts of opportunities still exist today. 

The next big thing
The 20- to 700-baggers of the next 12 years are out there right now, with their fuses lit and a wide-open sky above them. But they aren't Apache, valued at $25 billion today. They're also not companies like Wal-Mart, valued at $219 billion and covered by more than 20 Wall Street analysts.

They're small companies with strong founders and executive ownership north of 10%. Companies without debt concerns. Companies that generate excess cash from their operations, some of which already pay dividends. Companies that function without any real reliance on Wall Street for financing or table-pounding "strong buy" ratings.

I know it sounds contrary, but I want you to see that many of these small businesses offer low risk and high rewards for their long-term owners. How could a small company be less risky than a giant? Ask the former owners of WorldCom. That company wasn't just overfollowed -- it was fraudulently run!

The exact opposite exists with great small caps. They're well-run and underfollowed on Wall Street, creating price inefficiencies that strongly favor long-term investors.

Does that sound possible? Does it sound logical? It's certainly contrary.

What you should look for

Image source: Getty Images.

Our team at Hidden Gems advises you to track down the following:

• Founders with large personal stakes.
• Financial statements that are easy to read.
• A solid asset base with little or no debt.
• Price ratios that significantly undershoot growth rates of free cash flow.
• Dominant positioning in a profitable niche.
• Plenty of room to grow.

If you're inclined to think that every small-cap stock is doomed to have a larger competitor stomp it out, I ask you to return to my list of strong performers above. Each rose from obscurity because of sound financial management and shareholder-friendly practices. The free markets gave them plenty of maneuvering room.

But not every small company is poised for enduring success. Of the thousands of stocks in the small-cap universe, I find that 90% are too richly valued or too speculative, given the underlying business. That remaining 10%, however, contains hundreds of small caps that will beat the market, and dozens that will rise more than 30 times in value over the next 10 to 15 years.

You can read about this, and all of our Hidden Gems recommendations, right now, by signing up for a 30-day free trial. There is no obligation to subscribe.

This article was first published Sept. 24, 2003. It has been updated.

Tom Gardner is co-founder of The Motley Fool. He does not own shares of any company mentioned in this article. Wal-Mart Stores is a Motley Fool Inside Value recommendation. The Motley Fool owns shares of Terex. The Fool has a disclosure policy.