"Small-cap stocks squash large caps like grapes."
That's how I planned to open today. By now, I'd be making my case -- dropping obscure references like Nagel and Quigley and citing 70-plus years' of Ibbotson data.
And by ... now! My inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be hollering, or "What about survivorship bias?" And you're right. That's the fatal flaw with all historical data:
It's just a bunch of numbers, and the future is not the past.
So forget the numbers
You don't need me (or an Excel spreadsheet) to tell you that many of tomorrow's multibillion-dollar corporations are small, little-known companies today. It just stands to reason. The trick is distinguishing the winners from the also-rans without the benefit of hindsight.
Can we do it? It's not easy, but I think we can. I'll show you why I say so, but for now, just know that we will be looking for those rare smallish companies that are:
- Run by entrepreneurial zealots with ownership stakes.
- Free of convoluted relationships with banks.
- Able to grow their sales and cash flow exponentially.
And there's something else: You want a stock that hasn't hit Wall Street's radar yet. This way, you can benefit from pent-up institutional demand when earnings and revenues pick up, and the sell-side guys on Wall Street finally do catch on.
Now, what do I mean by "zealots"?
How about Apple's
This is nothing new. Decades before, Walt Disney essentially willed a tiny cartoon studio into a global Disney
None of which means that finding these companies is easy, but it can be done. More than anything, we need to be patient, have a plan, and pick our spots. Even better, we can steal a page from Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems playbook, seeking 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
Again, companies like that don't come along every day, but these five keys work. I already mentioned McNealy's Sun Microsystems. If you missed Sun Micro, you could have bought into Michael Dell's notion of selling computers direct to consumers, and done even better. Surely, there is another like them lurking out there right now.
But what are your chances of finding the next home run stock? Probably not as good or as bad as you may think. Earlier, I mentioned Motley Fool co-founder Tom Gardner. I personally witnessed how those five keys led Tom and his team of analysts to better-than-225% profits in less than two years, when Shire
Hidden Gems subscribers locked in another triple when GlaxoSmithKline
Yes, even in this market ...
Seriously, I hope you haven't given up on investing in innovative companies for the long term. If history is any guide, it will be small companies that will lead us out of this recession and into the next bull market. That's why I always have a wish list of great small caps on hand. You should, too.
If you're short on ideas, or if you want to share some of your own, you should consider trying out Hidden Gems free for 30 days. You don't have to subscribe to anything, and you can take a whole month to decide if it works for you. Meanwhile, you can check out the entire portfolio of small-cap value picks and download every back issue in five minutes.
As investors, it doesn't pay to be proud. We all need an edge and I've learned that there really is comfort in numbers, especially in rocky markets like this one. Take your time and be careful, but give up on stocks at your own risk. To learn more about this offer to try Hidden Gems free, simply click here.
This article was originally published May 10, 2005. It has been updated.
Paul Elliott does not own shares of any company mentioned in this article. FedEx, Apple, and Disney are Stock Advisor recommendations. Disney is also an Inside Value pick, as is Microsoft. GlaxoSmithKline is an Income Investor choice. The Motley Fool has a disclosure policy.