Pop quiz, hotshot. Name the company that's most likely to be a 10-bagger by 2020.
It's a hard question. There isn't just one correct answer -- you can find three candidates here -- but it's easy to weed out some popular incorrect answers.
If you named PepsiCo
He found that the largest grower of the past 10 years, weight-loss company Medifast, was better than a 90-bagger. Even at 90 times its original market capitalization, Medifast was just a $500 million company (it has fallen to $400 million since the beginning of this year). At $104 billion, Pepsi is some 200 times bigger; Procter & Gamble is more than 300 times bigger; and Microsoft is 500 times bigger.
It gets better
Besides having room to grow, small caps have another hidden feature. They are more volatile than their large-cap brethren. This can lead to fluctuations that are absolutely heartbreaking for investors with low risk tolerances. But for those of us with higher risk tolerance, the volatility provides opportunity.
As we've seen over the past couple years, large-cap stocks can be quite volatile, too. When their price losses significantly outstrip the market's, though, there's usually something terribly amiss.
Familiar examples abound:
(NYSE: JPM)-- Banking.
(Nasdaq: ERTS)-- Video games.
(NYSE: COH)-- Luxury goods.
(NYSE: DVN)-- Natural gas.
All of the above had huge downswings for good reason, be it an ailing industry or a lagging competitive position. That's not always the case for small caps, though.
A quick example
Let me take you back to fall 2008 and restaurant company Buffalo Wild Wings. In late October, it reported quarterly earnings that were disappointing. But given the state of the economy in general (read: panic) and the restaurant sector specifically, the results were downright robust: positive earnings-per-share growth and impressive same-store sales growth (6.8% at company-owned stores).
In response, shares were sliced in half in the month following the earnings release ... only to gain it all back and then some after the company beat analyst expectations in the subsequent quarter. Over the past few months, it has been the same company with the same long-term prospects. There have been no huge company-related events, and its price is about the same now as it was back then.
But somewhere in the middle, the market threw a half-off sale for investors patient enough to wait for a discounted entry point. Because they took advantage of volatility, those investors need only a five-bagger (or less) from here to reach the vaunted 10-bagger status.
The 10-bagger club
In 2020, when we look back at the decade's list of 10-baggers, the list will be dominated by stocks that can be described as:
The list of investors who profit from these 10-baggers will be dominated by people who can be described as:
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This article was originally published May 15, 2009. It has been updated.
Anand Chokkavelu owns shares of Microsoft. Buffalo Wild Wings is a Hidden Gems recommendation. Microsoft is an Inside Value choice. Electronic Arts is a Stock Advisor recommendation. PepsiCo and Procter & Gamble are Income Investor selections. Motley Fool Options has recommended diagonal call positions on Microsoft and PepsiCo. The Fool owns shares of Procter & Gamble and has a disclosure policy.