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Wall Street's Worst-Kept Secret

By Paul Elliott - Updated Nov 11, 2016 at 4:43PM

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Personal advice that might make you some money.

Hey, buddy! Want some personal investment advice?

If you own stocks, you should own small caps. OK, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you money.

You're serious about this
You want an edge. So why make this difficult? History tells us that investors who make the most money over the long term buy and hold common stocks.

At least they have since Ibbotson Associates started keeping track back in 1926 (and yes, I think it's still true, despite this dreadful market). Investors looking to goose their returns even more own small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy a small-cap exchange-traded fund (ETF) -- I own a few myself. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I have the occasional cup of joe with Motley Fool co-Founder Tom Gardner -- a guy who made a career out of beating Wall Street to profits on well-run small companies.

And you know what? I can admit that Tom and the team of analysts he hand-picked to manage his Motley Fool Hidden Gems newsletter service have assembled a portfolio of small caps I couldn't have found on my own. What's their secret? I think they focus more on value, while I tend to get wowed by story.

For all of that, we do look for many of the same things in a great small company:

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

I know it's hard to imagine, but these traits led investors to John Morgridge and Cisco Systems (NASDAQ:CSCO) back in the day; even Jeff Bezos and (NASDAQ:AMZN). Granted, you had to be nimble to get to Amazon ahead of Wall Street, but I don't have to tell you how those investments worked out.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least in their prime? And you're right. That's why it's so hard to beat the pros with well-known stocks like those now; if they're really all that, they're going to cost you.

But what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not well-known companies. There's a subtle difference if you think about it.

Consider big retailers such as Costco (NASDAQ:COST) and Home Depot (NYSE:HD), for example. They're both heavily owned by institutional investors now, but that wasn't always the case. Both had strong regional and even national footprints long before they were closely followed on Wall Street.

Need more proof?
Check out Fool Tim Hanson's list of the best-performing stocks of the past 10 years. You won't find a bunch of "widely helds" like Dell (NASDAQ:DELL) or Microsoft (NASDAQ:MSFT) on the list. Though don't be surprised if you recognize a company like drink-maker Hansen Natural from "real life" -- just as you probably recognized Costco and Home Depot from the strip mall. 

Of course, that's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these undiscovered gems. That's how he earned his Fidelity Magellan fundholders nearly 30% year after year.

What to do now
If what I'm saying makes sense, now might be the time to test the waters with a low-cost fund such as iShares S&P 600 Small-Cap Value Index (IJS) and then shift gradually into the small caps that Tom Gardner's team tells you about each month in Hidden Gems. Sooner or later, you want to be exposed to at least a few small businesses with big potential. Especially since these stocks typically rocket out of bad markets.

Even better, if you want to learn more about how Wall Street's worst-kept secret can help you beat the pros, accept a free trial to Hidden Gems. You can sneak a peek at all the current and past recommendations, including the analyst team's top five picks for new money right now.

You can even print out the entire catalogue of back newsletter issues, if you like. Best of all, the first full month is on me, and there's never any pressure to subscribe. Frankly, I never thought we'd see bargains like these again. I'm buying.

How about you? If you're looking for ideas and would like to learn more about this special free trial offer, simply click here.

This article was originally published Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P Small-Cap 600 Growth Index and the iShares S&P Small-Cap 600 Value Index. and Costco are Stock Advisor picks. Home Depot, Dell, and Microsoft are Inside Value picks. The Motley Fool has a full disclosure policy.


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Stocks Mentioned

Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
$541.90 (0.23%) $1.23
Microsoft Corporation Stock Quote
Microsoft Corporation
$280.32 (-0.92%) $-2.59, Inc. Stock Quote, Inc.
$139.41 (-0.99%) $-1.39
Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
$45.02 (0.02%) $0.01
Dell Technologies Inc. Stock Quote
Dell Technologies Inc.
The Home Depot, Inc. Stock Quote
The Home Depot, Inc.
$311.97 (0.74%) $2.28

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

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