Whisper-Stock Party Tips - By Paul Elliott

If you own stocks, you should own small caps. That's not necessarily so with micro caps. Here's why.

By Paul Elliott (TMF Rael)
February 10, 2006

You know who you are. I've been knocking around this business for years, and everywhere I've stopped I've met you. And every time I turn up someplace new, I take one or two of you along with me.

Behold! My own personal whisper-stock-party-tip rumor mill. One day, it's Mark on the phone from Rockville. Then it's Sean from Miami or Shannon from Boston. And just when you think you've heard it all, it's the other Mark from New York. He's got to be the worst.

The greatest stocks of all?
A while back, I made the case for Wall Street's worst-kept secret. It's that small stocks tend to outperform their larger-cap peers over time -- and that smart stock investors own them. What, then, is Wall Street's best-kept secret?

It's that micro caps do even better. At least a certain type of them do. I'll back that up with some numbers in a bit. I'll even toss in a few anecdotes, but first, some fine print.

Micro caps are not for everyone. They're for people like Sean and Shannon and the Marks. They're for people who love this stuff -- who have the time to do some real digging. Or have someone do it for them.(You'll hear more about one possible solution just ahead).

There has to be a better way
No offense to my old rumor mill, but it's hard to find decent research on tiny companies. Forget Wall Street. Not even the boutique shops offer much by way of coverage. Believe me, I've looked.

That isn't to say that the rumor mill doesn't have its place. I mean, we dug up a few killers over the years. We bought ImClone (Nasdaq: IMCL) years before Icahn got on boards. Then again, we also bought Genta (Nasdaq: GNTA) for a hellish ride. (We're taking our lumps on that one today, let me tell you!)

But I guess it stands to reason that our results would be mixed. After all, our method was never particularly rigorous, and the rumor mill deals in high hopes and speculations. No wonder we've had our ups and downs.

But do small companies have to be risky?
Maybe not. After all, Wal-Mart (NYSE: WMT) once had a market cap of less than $30 million. Yet the company made money. It was shareholder-friendly, conservatively managed, and heavily owned by its founders. But Wall Street's investment banks had little use for it.

Too bad for them. Hindsight is 20/20, and Wal-Mart is an extreme example, but it hardly seems Wal-Mart was ever a risky investment. After all, it actually paid a dividend, even when it was a small fry.

The Holy Grail, obviously, is to find companies today with the characteristics of a 1980s-era Wal-Mart. As with any small cap, look for these in any micro cap:

Solid management with significant stakes
Great, sustainable businesses
Dominant positions in niche markets
Sterling balance sheets
Strong free cash flow
Just look twice as hard. Because the smaller the company, the more important these things are. And look for micro caps that pay a dividend, like Wal-Mart did. A dividend implies a lot of good things, including that the company won't be out begging for new capital -- a great sign if ever there was one.

You didn't really have to find Wal-Mart
How about Biogen Idec (Nasdaq: BIIB) or even Schwab (NYSE: SCHW)? Both were long familiar names in very different circles, and yet both made fortunes for early investors. If you're a mall rat, you could have bought teen-themed retailer American Eagle Outfitters -- an original rumor-mill favorite -- as recently as 1997 for a 5,000% gain.

Of course, that's the beauty of getting in early. Consider Dell Computer. Had you bought Dell in 1990, you'd be up some 40,000%. But if you'd held off until January 1992, your $5,000 investment would be worth around $750,000 -- a lot of money, but downright paltry compared with the $2 million if you'd pulled the trigger just two years before.

And don't get me wrong, you could run out and buy IBM (NYSE: IBM) or Qualcomm (Nasdaq: QCOM) right now. And maybe you should, but neither can be the next big winner. With market caps in the hundred billions, what are the chances these guys can run up another 1,000% in value? Zippy.

Here's a little proof
I can't claim with any certainty that micro-cap stocks will continue to outperform over the next 20 years. Or that we can find the next big winners. I can't even promise that micro-cap value stocks will outperform. But they have in the past.

It's widely known that, since Ibbotson Associates started keeping data in 1926, small caps have thumped large caps. Well, Ibbotson also ran the numbers for micro caps, this time from 1968 to 2002. Turns out, micro-cap value stocks take the cake.

Illustration: $10,000 invested in micro-cap value stocks back in 1968 grew to nearly $1.1 million a quarter-century later. Compare that with around $950,000 for the same amount invested in small-cap value and just $180,000 for large-cap growth.

Now, how about that better way?
Micro caps aren't for everyone, but they sure are a blast. At the same time -- aside from walking the malls and scouring trade magazines -- how are you supposed to find out about these smaller companies? And with nobody following the stocks once you do, how can you stay on top of them?

Earlier, I hinted there might be a better way. Here it is. Motley Fool co-founder Tom Gardner follows small stocks for his regular readers at Motley Fool Hidden Gems. In fact, he's got a regular feature dedicated to micro caps. And it's not just Tom; the Tiny Gems discussion group is full of stock jocks turning over rocks all across the country.

In fact, you can sample the complete Hidden Gems service at no charge for 30 days. That way, you can see whether it's right for you without putting any capital at risk. Intrigued? To hear all about it, click here.

This commentary was originally published on Feb. 4, 2005. It has been updated.


Excerpted from Paul Elliott's article at
http://www.fool.com/news/commentary/2006/commentary06021005.htm