"Over the years, small-cap stocks crush their large- and mid-cap peers."
That's how I planned to start today. By now, I'd be laying out 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 a few abnormal years," you'd be shouting, or "What about survivorship bias?" And you'd be right. That's the fatal flaw with all historical data: The future is not the past.
So forget the numbers
You don't need an Excel spreadsheet to prove that many of tomorrow's megacaps are small companies today. But you do need a few clues if you want to find them ahead of the crowd. History suggests that you're looking for a smallish company ...
- Run by entrepreneurial zealots with ownership stakes.
- Free from convoluted relationships with investment banks.
- Able to rapidly grow its sales and cash flow.
And one more thing: You want a stock that hasn't hit Wall Street's radar yet. That way, there's a decent chance you can benefit from pent-up demand when earnings and revenue pick up and the sell-side analysts finally catch on.
So, what exactly is an "entrepreneurial zealot"?
Well, how about John Rockefeller? Sounds crazy, but you can trace ExxonMobil (NYSE:XOM), the largest companies in the world, to his Standard Oil. A little too dusty for you? Fair enough. How about Ray Croc's work at McDonald's (NYSE:MCD) in the 1960s?
In the 1970s, a guy named Fred Smith launched FedEx (NYSE:FDX) from a college paper. A few years before, Robert and Bruce Toll started a construction company called Toll Brothers (NYSE:TOL), now one of the nation's premier builders. You see where I'm going.
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 beauty of capitalism.
That's not to say finding them is easy, but it can be done. More than anything, we need to be patient and pick our spots. Even better, we can take a cue from my boss Tom Gardner's Motley Fool Hidden Gems method and seek out companies that have 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
In the 1990s, they led Peter Lynch disciples to a kid retailer calledAmerican Eagle Outfitters (NYSE:AEO) -- a stock that packed on more than 10 times its original value over the course of a decade. One in a million, you say? Not exactly.
The same thing happened with Chico's FAS (NYSE:CHS), another clothes hound that delivered monstrous gains to early investors. And then there's Seattle's other best, Nordstrom (NYSE:JWN), a more upscale retail multibagger.
So if you're looking for companies that will not only make it through to the other side of this brutal market but also have the potential to help you recoup your recent losses, start with those five keys.
Is this market killing you?
It's more frustrating than almost any other one that I've seen. But I don't believe that we've "jumped the tracks," as some folks are saying, or that it's different this time. That's why I can't see myself giving up on stocks for the long term and why I have a wish list of great small companies right here.
If you have a hunch what we've talked about today makes sense, how about this for a recession buster? Take a look at Motley Fool Hidden Gems free for 30 days. There's no pressure to join, and you have a full month to decide whether you like what you see. Meanwhile, you get to look over every small-cap value pick, including the analyst team's top five picks for new money right now.
This way, you'll be ready to move when you decide the market has turned the corner. But as I said, I'm already shopping for bargains. Plus, you have nothing to lose. To learn more about this special free trial and take a look at all the team's latest picks, click here.
This article was originally published on May 10, 2005. It has been updated.
Paul Elliott does not own shares of any company mentioned in this article. You can see the entire Hidden Gems scorecard, including every active and past recommendation, with your free trial. FedEx is a Stock Advisor recommendation. The Motley Fool owns shares of American Eagle and has a disclosure policy.
