"Over the years, small-cap stocks crush their large- and mid-cap peers."
I had every intention of starting this column with that bold statement. By now, I'd be making my case -- dropping obscure names like Nagel and Quigley and banging the table on 70-plus 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 hollering, or "What about survivorship bias?" And, of course, you'd be right. That's the fatal flaw with using historical data: The future is not the past.
So forget the numbers
Fortunately, you don't need an Excel spreadsheet to tell you that many of tomorrow's industry leaders are relatively unknown smaller companies today. It just stands to reason. What you may need, however, is a system to help you find them before they become household names. If history is any guide, we're looking for 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: Your odds of success increase dramatically if you can find a stock that hasn't hit Wall Street's radar yet. That way, you're positioned to benefit from pent-up demand when earnings and revenues pick up, and the sell-side analysts finally catch on.
But what do I mean, "zealots"?
How about David Filo and Jerry Yang? If you don't recognize their names, I'll bet you know their company, Yahoo!
You don't need to check these guys' SEC filings to know they have huge stakes in their businesses -- or see a stock chart to know they made early investors a ton of money. Moreover, there's one born every day. That's the beauty of the stock market, after all. Even if we're not geniuses, it lets us hitch our wagons to those who are.
Which is not to say that finding these guys 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 Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems method and seek out companies with market caps of less than $2 billion that offer us:
- 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, they don't come along every day, but they really do work. Digging around this morning, I was shocked to find that unassuming Lowe's
Love him or hate him, much the same happened with Rupert Murdoch's News Corp.
More recently, the five keys I just showed you led the team of analysts that Motley Fool co-founder Tom Gardner assembled at Motley Fool Hidden Gems to a double on China travel agent Ctrip.com
So has this market topped?
Nobody can say for sure. But I'm glad you didn't give up on stocks. And if history is any guide, small companies will lead us out of the recession. Irene Hoover, skipper of the Forward Small Cap Equity Fund, calls this a "once-in-a-generation opportunity." I agree.
That's why I have a wish list of great small caps on hand. You should, too. If you're short on ideas, here's another great opportunity:
You can try out Motley Fool Hidden Gems free for 30 days. You don't have to subscribe to anything, and you can take all that time 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 right now.
As investors, it doesn't pay to be too proud. We all need an edge and there's comfort in numbers, especially in markets like this one. Be careful, but risk missing out on the next bull market 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. Amazon.com and Starbucks are Motley Fool Stock Advisor recommendations. Starbucks is also an Inside Value pick. Ctrip is a Hidden Gems recommendation. The Motley Fool owns shares of Starbucks and has a disclosure policy.