"Over the years, small-cap stocks crush their large- and mid-cap peers."
That's how I planned to open this column today. By now, I'd be making my case – waving my hands and 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 outliers," 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 ain't the past.
So forget the numbers
Fortunately, you don't need Excel to prove that tomorrow's megacap household names are mostly small companies you’ve never heard of today. But you do need a few clues to find them before they take off. History suggests we're after a smallish 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: You want a stock that hasn't hit Wall Street's radar yet. That way, you can be there to benefit from pent-up demand when earnings and revenues pick up and the sell-side analysts start telling their brokers to buy.
What do I mean, "zealots"?
Remember the late Dave Thomas, the lovable face of Wendy’s (now Wendy's/Arby’s
You never needed to check these guys’ insider holdings to know they had big stakes in their businesses. And, thankfully, there's one more like them born every day -- even in down markets. That's the beauty of the stock market. We don't have to be a genius to hitch our wagons to one.
Which is not to say that 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 Tom Gardner's Motley Fool Hidden Gems method and seek out companies with market caps of less than $2 billion that offer:
- Solid management with big stakes in the company.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sterling balance sheets.
- Strong free cash flow.
Just remember those five keys
Back in the '80s, they led designing types like my pal Ricky to Adobe Systems
Not a techie? No worries. As a stock guy, I caught Joe Ricketts' enthusiasm for what is now TD Ameritrade
More recently, those same five keys led the hand-picked team of analysts that widely followed small-cap hunter Tom Gardner has assembled to a portfolio full of promising small-cap recommendations.
Is this market killing you?
Honestly, I feel your pain. I admit it: I vastly underestimated the selling pressure we’ve endured over the past year. Could we see more? Sure. Could we suffer the big pullback everybody's waiting for? It's possible.
But I'm not buying the rumors that the stocks are dead. I've been a buyer recently, but I’ve got some powder left. And I'm looking to buy more on weakness. I truly believe that these are times we’ll look back on fondly. That's why I have a wish list of great small companies on hand for times like this. You need one, too.
If you're short on ideas, you might consider checking out Hidden Gems. It's free for a full month, while you decide if it helps you make money. When your trial is up, you don't have to join. Meanwhile, you can check out all the issues and every recommendation on day one, including the team’s top five picks for new money right now.
Seriously, if you’ve ever considered giving Hidden Gems a shot, this really is the time to do it. The team has just launched a real-money portfolio, and you won’t believe the early results. To check it out and learn more about this free special trial, simply 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. eBay is both a Stock Advisor and Inside Value recommendation. Google is a Rule Breakers selection. Intuit is an Inside Value pick. The Motley Fool has a disclosure policy.