"Over the years, small-cap stocks crush their large- and mid-cap peers."
That's how I planned to start this little ditty. By now, I'd be making my case, waving my arms and dropping names like Nagel and Quigley and citing 80 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. This is the fatal flaw with all historical data: The future is not the past.
So forget the numbers
Fortunately, we don't need an Excel spreadsheet to tell us that the widely held mega-cap companies of tomorrow are small, unknown companies today. But we 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 can benefit from pent-up demand when earnings and revenue pick up and the mainstream press and 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
Then, there’s perhaps my favorite of all, Jim Sinegal at Costco
Which is not to say that finding these guys is easy, but I 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 screen the market for 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 a neighborhood hardware chain that grew into Home Depot
As a stock guy with little interest in gabbing with a full-service broker, I caught Bill Porter's enthusiasm for E*Trade
Right now, they are leading my colleagues Seth Jayson and Andy Cross -- and their team of analysts working in the service of members of Tom Gardner's Motley Fool Hidden Gems newsletter service -- to a new crop of up-and-coming, fundamentally strong businesses.
Is this market wearing you out?
Honestly, I feel your pain. I admit it: I underestimated the selling pressure we endured over the past year or so. Could we see more, even despite the recent good vibes? Sure. Could we suffer the big pullback everybody's waiting for? It's possible.
But I'm not buying the rumors that 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 should have one, too. Here's an idea: Do what I do -- lean on the team of advisors at Hidden Gems for ideas and advice. They've never led me wrong. And right now, you can try the entire service free for a whole month.
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Best of all, you're not taking any chances. If you're not impressed at any point during your 30-day trial, I'll personally make sure you don't pay you a dime. Buffett would be proud. To learn more about this free trial offer, 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.