Want to Find Home Run Stocks? Look for This

I think it goes without saying that you would love to see returns like these in your portfolio:

Source: Capital IQ, a Standard & Poor's company.

These were the top performers in the "lost decade" of the 2000s. But how do you score home run stocks like these? As my fellow Fool Tim Hanson has pointed out, you look for small and ignored companies, a description that fit all of the above companies a decade ago.

Many mutual funds are simply too large to be able to buy meaningful amounts of smaller companies, and so they're stuck trying to juice returns from huge blue chips like IBM (NYSE: IBM) and Wal-Mart (NYSE: WMT). Don't get me wrong, both of these are great companies. By largely eschewing hardware growth in favor of software and services, IBM has set itself up for a much more profitable future, while Wal-Mart's amazing global retail dominance will likely mean that shareholders will be rewarded for years to come. But the simple truth is that you're just not going to see these two soar 5,000% over the next decade.

Meanwhile, the tiny up-and-comers that can provide massive returns are completely ignored, which gives individual investors a fantastic opportunity to find them before Wall Street does.

There's a but ...
While there are no optical illusions or sleight of hand in that chart above, it's worth noting that while the absolute best performers over the past decade were small-cap stocks, small caps also accounted for about 95% of public-company bankruptcies.

With that in mind, we could probably say, "Live by the small cap, die by the small cap." That is, unless we could find something that separated those top-performing small caps from those that went belly-up.

Will any idiot do?
To try and find a way to separate the wheat from the chaff among small caps, I decided to start at the top -- the top of the management team, that is. For each of the top-performing companies and 10 randomly selected bankrupt companies, I dug up proxy filings from a decade ago to get a look at who was steering the ship.

What I found was frankly a little surprising, but it wouldn't shock Fool co-founder Tom Gardner at all; he's been crowing about this for some time. What am I talking about? Insider ownership.

Here's a look at the CEO's ownership stake in each of the successful companies:

Source: Company filings.

Compare that with the ownership levels for the companies that went bust:

Source: Company filings.

The CEOs of the bankrupt companies didn't completely avoid share ownership, but it's pretty easy to see that on average, the heads of the successful companies owned a far larger percentage of the companies they managed.

In addition, the CEOs of the successful companies were far more likely to be one of the company's founders. Half of the CEOs in that first list were founders, while there is only one founder/CEO in the second list.

Take a look at Green Mountain Coffee and Hansen Natural in particular. Even among the most successful stocks, these two shine, and the CEOs of both companies owned massive chunks of company stock. I have little doubt that those ownership stakes encouraged the CEOs to think like shareholders as they grew the company.

A step in the right direction
Insider ownership by itself is certainly no silver bullet. Looking back to 2000, both Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) had founder/CEOs who owned big chunks of stock. Both companies have performed quite well since then, with operating profit growth of 108% and 200%, respectively. Both are also very well-respected companies today and are likely even good investments (at least as far as large caps go).

But that all matters little to investors who bought back in 2000, because both stocks have performed poorly over the past decade, an outcome that had a lot to do with the fact that both companies carried absurd valuations.

At the outset of this article, I highlighted Tim Hanson's insight that the best-performing stocks over the past decade are small, ignored companies. Now I think we can add a couple of more qualifiers to winnow down our list:

1. Small, ignored companies.
2. Reasonable valuations.
3. CEOs that own a significant chunk of stock (and preferably are founders).

Are there companies out there that fit the bill? You bet. Yingli Green Energy (NYSE: YGE) and Navios Maritime -- two small-cap companies taking on the alternative energy and shipping spaces -- both have CEOs who own 20% or more of the company's outstanding shares. The stocks also are currently trading at attractive valuations.

Of course when trying to find these undiscovered beauties in the world of obscure companies, it can help to have experienced guides. For nearly seven years, the team at Motley Fool Hidden Gems has been helping subscribers charge up their portfolios with exactly these kinds of companies.

Today, Hidden Gems maintains a real-money portfolio that includes the team's 10 "buy first" recommendations. If you'd like to get a peek at these top picks along with the rest of the Hidden Gems recommendations, you can take a free 30-day trial of the investing service.

Fool contributor Matt Koppenheffer owns shares of Wal-Mart, but does not own shares of any of the other companies mentioned. Microsoft and Wal-Mart Stores are Motley Fool Inside Value picks. Green Mountain Coffee Roasters and Hansen Natural are Motley Fool Rule Breakers selections. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of XTO Energy. The Fool's disclosure policy likes sports metaphors as much as the next investor.