Hey buddy, want some personal investment advice?
If you own stocks, you should own some small caps. Of course, there's nothing personal about that. In fact, it's Wall Street's worst-kept secret.
You're serious about this
You want an edge. So, why make this difficult? Everybody knows 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 tabs back in 1926. Investors who make even more buy small-company stocks, also according to Ibbotson.
The way I see it, we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). Or we can get to work building a 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've been at this for a few years, but I also down the occasional cup of joe with Tom Gardner. Tom has made a career out of beating Wall Street to well-run small companies.
And you know what? I'm man enough to admit that the team of analysts Tom hand-picked to run his Motley Fool Hidden Gems investment advisory service has assembled a portfolio of small caps that I probably wouldn't have found on my own. What's their secret? I think it's that they focus on value, while I love a good story.
Yet for all our differences, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. Smart investors have always looked for:
- 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 gave investors the courage to follow young Scott McNealy into Sun Microsystems
Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those now -- if they're really all that, they're going to cost you.
So, 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 companies. There's a difference.
For example, big retailers like TJX
Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. Just don't expect to find Alcoa
In fact, I'm willing to bet that Green Mountain Coffee Roasters
You see, there's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these hidden gems, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% year after year.
How to get rolling
Don't get me wrong; these bottle rockets aren't easy to find. But I hope you can see how this is great news for investors like us -- especially after all we've been through this year. These examples prove that we can find established, profitable companies with unknown stocks and ride them to big profits. Some you will have heard of; others you may not have -- yet.
As for relying on the next Peter Lynch, a word of warning: Outperforming with a mutual fund is a crapshoot. That's why I like exchange-traded funds (ETFs) -- you get broad exposure to an entire group (like small caps) without the management fees associated with managed funds. Both the iShares S&P SmallCap 600 Growth (IJT) and Value (IJS) indexes are solid choices.
Here's a better idea
If you ask me, a strategy of starting with these ETFs and scaling gradually into the stocks you can hear about each month in the Motley Fool Hidden Gems newsletter is a winner. After all, you want to be diversified, but sooner or later, you'll want a little more exposure to a few great small businesses with massive potential. That's where the money is.
And now is the time to start looking. The Street is littered with bargains. If you're ready to buy, but you need a little encouragement and some good stock ideas, accept a free trial of the complete Hidden Gems service. You can check out every current and past recommendation (including the team's top five picks for new money now).
You can even read all the newsletter issues online and print them out if you like. There's no pressure to subscribe, and your first month is on me. That's how convinced I am that it's time to start shopping. To learn more and have a look, simply click here.
This article was originally published on Jan. 7, 2005. It has been updated.
Paul Elliott owns shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. Green Mountain Coffee Roasters is a Rule Breakers recommendation. Intel, Dell, and Pfizer are Inside Value picks. The Motley Fool owns shares of Pfizer and covered calls on Intel. The Motley Fool has a full disclosure policy.