"Over the years, small-cap stocks crush their large- and mid-cap peers."
That's how I planned to start today. 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 know what? You'd be right. 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 megacap companies of tomorrow are mostly small, unknown companies today. It's a historical certainty.
But we do need a few clues to find them ahead of the crowd. If history is any guide, we should be looking for a smaller company ...
- Run by entrepreneurial zealots with ownership stakes.
- Free of convoluted relationships with investment banks.
- Able to grow 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 (NYSE: WMT). But you can go all the way back to Henry Ford and Ford Motor (NYSE: F) -- yes, hard as it is to believe now, Ford really was a great company in its day. More recently, you have John Mackey at Whole Foods (Nasdaq: WFMI). Then, there's perhaps my favorite of all, Jim Sinegal at Costco (Nasdaq: COST).
You never had to check these guys' insider holdings to know they had huge stakes in their businesses. And, thankfully, there's another one born every day. That's the real beauty of the stock market. It lets us hitch our wagons to the folks who do the heavy lifting for us.
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 screen the market specifically for companies with market caps of less than $2 billion that offer:
- Solid management with big stakes.
- 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 (NYSE: HD) -- a stock that packed on more than 20 times its original value during the '90s alone. One in a million, you say? Not exactly.
As a stock guy with little interest in gabbing with a full-service broker, I caught Bill Porter's enthusiasm for his little outfit called E*TRADE (Nasdaq: ETFC) back when online brokers were just catching on -- just as millions of investors before me had discovered Charles Schwab's (Nasdaq: SCHW) revolutionary low-cost discount model.
Right now, these five keys are leading my colleagues Seth Jayson and Andy Cross at the Motley Fool Hidden Gems investment 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 sell-off and was blown away by the bounce back. Could we see more volatility? Sure. Could we suffer the last big pullback everybody's waiting for? It's possible, I guess.
But I'm not buying the rumors that buy-and-hold investing is 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 independent 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.
Even better, the Hidden Gems team is putting its money where its mouth is; investing real money in their top picks right now. You can get the names of every stock they've bought, plus the one they're going to buy next, and get in before they invest.
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 a dime. Even Warren Buffett would be proud. To learn more about this free trial offer, click here.
This article was originally published 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.
