Get Ready to Buy - By Paul Elliott

By Paul Elliott (TMF Rael)
February 6, 2006

"Over the years, small-cap stocks crush their large- and mid-cap peers."

That's how I planned to open today. By now, I'd be making my case -- dropping names like Nagel and Quigley, plus 70 years' worth of market data from Ibbotson.

But you're no dummy
And by ... now! ... my inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be shouting, or "What about survivorship bias?" And you'd be right. You'd have found the fatal flaw in all historical data: The future is not the past.

So forget the big numbers
Fortunately, you don't need an Excel spreadsheet to tell you that tomorrow's big winner is an upstart today. What you need is a few clues to help you find it. And history tells us that the one stock you'll brag about is very likely ...

Run by entrepreneurial zealots with ownership stakes.
Free of convoluted relationships with investment banks.
Positioned to grow its sales and cash flow exponentially.
But most important, this company is out there right now. And because Wall Street hasn't found it (yet), you can count on some pent-up demand to fuel the fire when the sell-side herd finally does catch on.

Get in near the ground floor?
My father once told me, "Be your own boss, and you'll die rich." He had a point. After all, investors who bought Wendy's (NYSE: WEN) in Columbus and Hershey (NYSE: HSY) in Lancaster hit the jackpot. But even those lucky devils didn't fare as well founders Dave Thomas and Milton Hershey. Of course, that's how capital works.

Think about it: The nearer your grandfather got to kindly old Henry, the sweeter his investment in Ford (NYSE: F). And just imagine the possibilities if his father had been a drinking pal of J.P. Morgan. You'd be a JPMorgan Chase (NYSE: JPM) millionaire.

Sadly, most of us don't build empires, plant seed money, or ever really encounter pure genius. But thanks to the stock market, we can still get in early. We just need to be patient and pick our spots. Better still, we can take a cue from Tom Gardner's Motley Fool Hidden Gems method and seek out companies with market caps below $2 billion offering:

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
In the early '90s, they led tech investors to mavericks like Cisco (Nasdaq: CSCO) and AOL (now part of Time Warner (NYSE: TWX)) -- and fantastic profits. Just as they led folks to Home Depot (NYSE: HD), among many others. In just the past two years, they have led Tom and his gang at Motley Fool Hidden Gems to a half a dozen stocks that have doubled in value or more.

(To be fair, I'll give you the whole story. As of Feb. 5, 2006, the stocks recommended in Hidden Gems are up on average 37.9%. That's compared with about 11.3% if you'd bought the S&P 500 instead. You can see the difference for yourself.)

For most investors, 2006 started out with a bang, but the market looks to be cooling off. I don't know about you, but I am a buyer on any weakness. Either way, I always have a wish list of small stocks on my watch list when opportunity knocks. You should, too.

If you need some help putting one together, here's a possible shortcut. You can try Tom Gardner's complete Hidden Gems service free for 30 days. Of course, there is no obligation to subscribe, and you have a whole month to decide. But you can get the full list of Tom's recommendations instantly. Click here to learn more.

This article was originally published on May 10, 2005. It has been updated.

Excerpted from Paul Elliott's article at
http://www.fool.com/news/commentary/2006/commentary06020603.htm