One Stock Winner. One Stock Loser.

Today, I'm going to tell you about a recommendation I made as co-advisor in our small-cap investing service, Motley Fool Hidden Gems. Actually, I'm going to tell you about a recommendation that is currently down 51% on our scorecard, 22% worse than the return produced by the S&P 500 over that same period.

I’ll take "morons" for $1,000, please.
By now, you probably think I'm an idiot, but hear me out. (By the end of the article, if you still think I'm an idiot, there's plenty of room to tell me so in the comments section.) I think it's important to examine your investment whiffs in order to get better for the future. There's nothing like investing in stocks if you want to be wrong. And luckily, some of the lessons are painful enough to really get your attention and help you sharpen your game.

However, just so you think I wasn't born 100% free of the P.T. Barnum gene, I'm also going to tell you about a company that quickly doubled after we purchased it with our real-money Hidden Gems small-cap portfolio. (This same stock nearly tripled from the time we discussed it on our dedicated message boards and told members that it was ludicrously priced. Alas, our real-money portfolio didn't begin until after it had run up a bit, so those big gains went to some of our members.)

Stock No. 1
The first stock was a beaten-down small cap. It was a former high-flier that looked newly inexpensive, having lost half its value in a spring 2008 market swoon. In late 2008, despite the drop from the $60s to the $30s, the company itself was still riding a wave of heavy investment in oil and gas, with explosive revenue and profit growth. However, as the recession took hold and the commodities boom showed itself to be a bubble, it was crushed along with the price of oil -- and the prospects of dwindling investment in that industry. However, the price dropped a lot more, flirting with $5 a share during the depths of the early 2009 market panic. The lesson? Cyclicality happens, and even if everyone's predicting $200-a-barrel oil, that doesn't mean it won't see $30 a barrel first.

Stock No. 2
The second stock was another small cap that looked like a great value. It also operated in a pretty cyclical sector, creating specialized metal cladding materials for various industrial uses, especially in oil and petrochemicals, but also in metal production, alternative energies, and even ship parts. By the time we added this stock to our portfolio, the market had gotten over the worst of its jitters, and the stock had rebounded for a double. However, it still looked pretty cheap to us, and within weeks of our buying it, it had nearly doubled again.

Make up your mind
Those of you who follow the explosive cladding business (more exciting than American Idol, really) have already probably figured out that stock No. 2 is Dynamic Materials (NASDAQ:BOOM). Only the most avid fans of titanium-steel composites are likely to realize that stock No. 1 is also Dynamic Materials.

So which is it, then: a 50% loser or a better-than-100% gainer?

That, of course, depends on what investors did with Dynamic Materials, and when. At Hidden Gems, we certainly weren't happy with the way the commodities bubble burst and took Dynamic Materials with it. However, when we re-examined the company, we saw a leading provider of specialized materials, with a substantial moat, trading as if it were distressed. Sure, the company had some debt and many of the energy industry contracts on which it depends looked iffy, but we knew that eventually, customers would need what Dynamic Materials provides, and we also thought it very unlikely that it would find itself in financial difficulty before the turnaround would come.

I should note here that the turnaround hasn't come yet. The most recent quarterly report showed a continuing drop in Dynamic Materials' revenues and backlog as projects are pushed back amid financial uncertainty. But Mr. Market seems to believe, as we do, that a turnaround is likely to happen soon enough. And that's why the stock is no longer trading for the price of a value meal -- without the super-size. However, with the recent swoon, it's no longer a quick double, either.

The way it is
This is hardly a unique story. During this year's unprecedented market mayhem, many stocks took similarly wild rides. A quick check with my handy Capital IQ screener finds more than 400 small caps that lost 70% of their value, then tripled, during the past year. However, not all these movers were created equal. When you begin straining them out by financial health -- for instance, by insisting on interest coverage of 3 or better -- the number drops to just more than 100. Dynamic Materials was among that elite group. Others include

Data provided by Capital IQ, as of Aug. 16, 2009.

There were other Hidden Gems stocks on the list as well, but some of these were in very precarious positions regarding debt covenants, or had other operational difficulties that made them far riskier. In other words, after the storm has passed, it's easy to be impressed with the survivors. But during the worst of it, the list of companies that looked both cheap and safe was a lot smaller.

Investing in the real world
The difference between what happened to Dynamic Materials No. 1 and Dynamic Materials No. 2 illustrates the difficulties that face long-term small cap investors. Great ideas aren't so great when the timing is off. However, by studying the (forgive me) dynamics of a small company's markets, understanding its cash flows, and upping your bets when the market is showing more stress than sense, sharp investors can mitigate losses, add to winning companies when they're cheap, and reap the gains.

Foolish final thought
In order to meet that reality, we redesigned our Motley Fool Hidden Gems service to go beyond simply finding promising investing stories. We still present our two best ideas every month -- but like other passionate investors out there with street smarts, we don't simply make a one time, one-way bet and cross our fingers, hoping for a market-beater. We watch our companies like hawks, run numbers constantly, weigh allocations carefully, and open positions only when Mr. Market offers up the bargains. We stop buying when the price is high (and sell when shares are just too expensive). And just like you, we do it all with real money, not fantasy cash.

Because Mr. Market is always fickle, and he'll almost always offer you up a better price than the one you see the first time you find a great company. We think this offers a better way to build a small cap portfolio, from the ground up, one stock at a time. If you'd like to take a look at how we're doing it, and join our active community of small-cap aficionados, a risk-free trial is on me.

Seth Jayson is co-advisor of Motley Fool Hidden Gems, and owns no companies mentioned in this article. Rackspace Hosting is a Motley Fool Rule Breakers recommendation. Dynamic Materials is a Motley Fool Hidden Gems selection. The Motley Fools owns shares of Dynamic Materials.