Pop quiz, hotshot: Name the company that's most likely to be a 10-bagger by 2020.
In fairness, that's a hard question with no single correct answer. (You can find three candidates here.) But it's definitely easy to weed out some popular incorrect answers.
If you named Pepsi, Procter & Gamble, Microsoft, or any other large-cap company, you're probably wrong. They're simply too big to grow tenfold in the next decade. My Foolish colleague Tim Hanson has shown year in and year out that a decade's biggest winners come from small-cap stocks.
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 larger; Procter & Gamble is more than 300 times larger; and Microsoft is 500 times larger.
It gets better
Besides having room to grow, small caps have another hidden feature: They're more volatile than their large-cap brethren. This can lead to absolutely heartbreaking fluctuations 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 of years, large-cap stocks can be quite volatile, too. But when their price losses significantly outstrip the market's, there's usually something terribly amiss. Familiar examples abound.
Despite its high-quality name, Wells suffered because the entire banking industry was in tatters, complete with bailouts and talk of nationalization. US Bancorp
The maker of Grand Theft Auto has yet to prove consistent profitability, so today's discount may be justified.
This growth darling freaked out investors when its size and the recession stalled its growth. Now that things are looking up, it's back, trading at moderate growth stock multiples.
Natural gas prices peaked in 2008, leading to a run-up in Chesapeake's stock price ... and a big fall when natural gas prices subsequently tanked. Competitors Devon and EOG Resources
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. In late October, restaurant company Buffalo Wild Wings reported disappointing quarterly earnings. But given the state of the economy in general (read: panic) and the restaurant sector specifically, the results were downright robust. Buffalo Wild posted positive earnings-per-share expansion 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. The whole time, Buffalo Wild stayed the same company, with the same long-term prospects. No huge events shook up its fortunes, 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:
If you have these two qualities, I invite you to join our analysts at the Motley Fool Hidden Gems newsletter. They're putting the Fool's money where its mouth is by building a real-money portfolio of small-cap stocks. You can see all the companies they're investing in with a free 30-day trial. If you're not impressed, there's no obligation to subscribe.
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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 Motley Fool Hidden Gems pick. Chesapeake Energy and Microsoft are Motley Fool Inside Value picks. Take-Two Interactive Software is a Motley Fool Rule Breakers choice. Starbucks is a Motley Fool Stock Advisor selection. Pepsi and Procter & Gamble are Motley Fool Income Investor selections. Motley Fool Options has recommended a diagonal call position on Microsoft and a "roll your diagonal call" position on Pepsi. The Fool owns shares of Chesapeake Energy and Procter & Gamble and has a disclosure policy.