Wall Street's Worst-Kept Secret

The way I see it, we have a few choices. We can roll the dice on a small-cap mutual fund. We can buy a small-cap exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. I recently had the pleasure of chatting with Motley Fool co-founder Tom Gardner -- a guy who's made a career out of digging up well-run small companies ahead of Wall Street.

I'm beginning to suspect that Tom is onto something, and that the team he assembled to run his Motley Fool Hidden Gems newsletter service has built a solid portfolio of small companies I couldn't have found on my own.

What's their secret? When analyzing small companies, I think these guys focus on fundamentals, while I tend to get wowed by story. More specifically, they insist on a few important criteria when searching for great small companies:

• Solid management with significant stakes.
• Great, sustainable businesses.
• Dominant positions in niche markets.
• Sterling balance sheets.
• Strong free cash flow.

I know it's hard to imagine now, but many of these same traits gave investors the courage to follow a young Howard Schultz into Starbucks (Nasdaq: SBUX), a longtime Motley Fool favorite. The same goes for Sam Walton and Wal-Mart back in the 1970s. Both were pretty decent investments for years.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own names like Starbucks and Wal-Mart -- at least in their prime? And you're right. That's why it's so hard to beat the pros with familiar stocks like those when they're hot; if they're really all that, they're going to cost you.

But what are you going to do? Take a chance on some fly by-night outfit? Good point. But notice I said well-known stocks -- not necessarily well-known companies. There's a difference.

For example, flashy tech outfits with sexy names like Level 3 Communications (Nasdaq: LVLT) and Tellabs (Nasdaq: TLAB) are often familiar tickers long before many traders figure out what they actually do. Companies like BJ Wholesale Club (NYSE: BJ), on the other hand, have strong regional and even national footprints long before they hit Wall Street's radar.

Need more proof?
Check out my buddy Tim Hanson's list of the best-performing stocks of the past 10 years. But don't expect to find a bunch of sexy story stocks like Sirius XM Radio (Nasdaq: SIRI) or Suntech Power (NYSE: STP). In fact, I'm willing to bet you haven't heard of more than one from your broker, though you might recognize a bunch from "real life" -- Green Mountain Coffee Roasters (Nasdaq: GMCR), for example.

And that's your edge: You can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these gems. That's precisely how he earned his Fidelity Magellan (FMAGX) shareholders nearly 30% year after year.

Of course, outperforming with a mutual fund is a crapshoot. That's why I'm a fan of exchange-traded funds (ETFs) -- you get broad exposure to the entire group without the management fees associated with typical funds. I've done well with both the iShares S&P 600 Small-Cap Growth Index (IJT) and its value compatriot.

What to do now
If what I'm saying makes sense, now might be the time to test the waters with a low-cost ETF such as iShares S&P 600 Small-Cap Value Index (IJS) and then shift gradually into the small caps the experts tell you about each month in Hidden Gems. Sooner or later, you want to be exposed to at least a few small businesses with big potential. Especially since these stocks typically rocket out of down markets like this one.

Even better, if you want to learn more about how Wall Street's worst-kept secret can help you beat the pros with much less work and aggravation, accept a free trial to Hidden Gems. You can sneak a peek at all the current and past recommendations, including the analyst team's top five picks for new money right now.

Copyright © 2008 Universal Press Syndicate.