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Get Ready to Buy

By Paul Elliott - Updated Nov 11, 2016 at 4:44PM

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Here's a simple recipe for tough times.

"Over the years, small-cap stocks crush their large- and mid-cap peers."

That's how I planned to start. By now, I'd be making my case -- dropping names like Nagel and Quigley and 70 years' worth of Ibbotson data.

And by ... now! My inbox would be full. "Your numbers are skewed by abnormal years," you'd be shouting, or "What about survivorship bias?" And you'd be right. It's the fatal flaw with all historical data: The future is not the past.

So forget the numbers
Fortunately, you don't need an Excel spreadsheet to tell you that the widely held megacaps of tomorrow are small, unknown companies today. But you do need a few clues to find them ahead of the crowd. If history is any guide, you're looking for a smaller company ...

  • Run by entrepreneurial zealots with ownership stakes.
  • Free of convoluted relationships with investment banks.
  • Able to grow its sales and cash flow exponentially.

And one more thing: Assuming the stock hasn't hit Wall Street's radar yet, there's a decent chance you'll benefit from pent-up demand when earnings and revenue pick up and the sell-side analysts finally jump on the bandwagon.

So, what's an "entrepreneurial zealot"?
One of my all-time favorites is Sam Walton, founder of Wal-Mart (NYSE:WMT). But you can go all the way back to Henry Ford and Ford Motor (NYSE:F) -- yes, Ford was a great company in its day. More recently, you have John Mackey at Whole Foods (NASDAQ:WFMI) and Jim Sinegal at Costco (NASDAQ:COST).

You never had to check these guys' insider holdings to know they had huge stakes in their businesses. And, thankfully, there's another one born every day. That's the real beauty of the stock market. It lets us hitch our wagons to the folks who do the heavy lifting for us.

Which is not to say that finding these guys is easy, but I really think you can do it. More than anything, we need to be patient and pick our spots. Even better, we can take a cue from Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems method and specifically seek out companies with market caps of less than $2 billion that offer:

  • Solid management with big stakes in the companies.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

Just remember those five keys -- they work
In the '80s, they led thousands of do-it-yourselfers to the hardware chain that grew into Home Depot (NYSE:HD) -- a stock that packed on more than 20 times its original value during the '90s alone. One in a million, you say? Not exactly.

As a stock guy who was getting eaten up by commissions, I caught Bill Porter's enthusiasm for E*Trade (NASDAQ:ETFC) back when online brokers were just catching on -- just as millions of investors before me discovered Charles Schwab's (NASDAQ:SCHW) revolutionary low-cost discount model.

More recently, they led my colleagues Seth Jayson and Andy Cross and their team of analysts working on behalf of members of Tom Gardner's Motley Fool Hidden Gems newsletter service to a handful of small-cap stocks that have doubled over the past five or so years.

Is this market killing you?
I'm the first to admit that I'm frustrated -- and that the sell-off has surprised me in its intensity. But I'm still not buying the doom and gloom. I'm thinking long-term, and I'll be buying the dips. That's why I always have a wish list of great small companies on hand. You may need one, too.

If you're short on ideas, you can try out the complete Hidden Gems small-cap newsletter free for 30 days. There's no pressure to join, and you have a full month to decide if it makes you money. Meanwhile, you can get every past and current recommendation, including the team's top five picks for new money right now.

This way, you'll be ready to jump when you decide the market has turned the corner. But like I said, I think we're there, and I'm already shopping. To learn more about this special free trial, simply click here.

This article was originally published on May 10, 2005. It has been updated.

Paul Elliott owns no shares of any company mentioned in this article. Costco, Wal-Mart and Home Depot are Inside Value recommendations. Schwab, Costco, and Whole Foods are Stock Advisor recommendations. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Wal-Mart Stores, Inc. Stock Quote
Wal-Mart Stores, Inc.
WMT
$129.82 (0.96%) $1.24
Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$532.20 (-1.41%) $-7.62
Ford Motor Company Stock Quote
Ford Motor Company
F
$15.83 (2.13%) $0.33
Whole Foods Market, Inc. Stock Quote
Whole Foods Market, Inc.
WFM
The Home Depot, Inc. Stock Quote
The Home Depot, Inc.
HD
$310.69 (-0.29%) $0.89
The Charles Schwab Corporation Stock Quote
The Charles Schwab Corporation
SCHW
$72.57 (4.09%) $2.85
E*TRADE Financial Corporation Stock Quote
E*TRADE Financial Corporation
ETFC

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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