Brace yourself, because here it comes: "Over the years, small-cap stocks outperform their large- and mid-cap peers."
That's how I planned to open this column. By now, I'd be making my case -- waving my hands like a maniac and dropping obscure names like Nagel and Quigley and citing 70 years' worth of Ibbotson data.
And by ... now! My inbox would explode. "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, we don't need an Excel spreadsheet to show that tomorrow's megacap household names are mostly small companies you’ve never heard of today. It simply stands to reason.
Of course, to make the easy money, you need to find them before they take off. It’s not easy, but there are a few tricks to tip the odds in your favor. 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, the guys on “Bulls and Bears” catch wind, and the sell-side analysts start telling their brokers to Buy! Buy! Buy!
What do I mean, "zealots"?
Remember the late Dave Thomas, the lovable face of Wendy’s (now Wendy's/Arby’s (NYSE:WEN))? Or how about Herb Kelleher, the no-nonsense peanut-tossing founder of Southwest Airlines (NYSE:LUV)? Even those "don't be evil" guys from Google (NASDAQ:GOOG) will do, though I bet you can't pull their names.
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 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:
- 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 arty types like my pal Ricky to Adobe Systems (NASDAQ:ADBE) -- a stock that packed on more than 10 times its original value during the '90s. One in a million? Not quite. Much the same happened with Scott Cook's Intuit (NASDAQ:INTU).
As a stock guy, I caught Joe Ricketts' enthusiasm for a discount brokerage now called TD AMERITRADE (NASDAQ:AMTD) back when online brokers were just catching on. Meanwhile, millions were discovering Pierre Omidyar's eBay (NASDAQ:EBAY), though you had to be quick to get in early on that one.
More recently, those same five keys led widely followed small-cap hunter Tom Gardner and his handpicked team of analysts to a portfolio full of promising small-cap recommendations -- including 17 picks that have doubled or more.
Worried you missed the rally?
Honestly, I feel your pain. I’ve been nibbling, but I've got some dry powder left myself. So I'm looking to buy more on weakness. I truly believe that these are times small-cap investors will 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 think I might be right, you should consider checking out Hidden Gems. You can sample the entire service for a full month free, while you decide if it helps you make money. If not, you don’t pay. Meanwhile, you can print out all the issues and every recommendation in five minutes, including the stocks the team is buying for its real-money portfolio.
Seriously, if you’ve ever considered giving Hidden Gems a shot, right now is the time to do it. The analyst team just recently launched a $250,000 real-money portfolio, and you’ll be impressed by the early results. To check it out and learn more about this free special trial, simply click here.
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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. Adobe is a Stock Advisor choice. The Motley Fool has a disclosure policy.
