The Small-Cap Investor E-Book

Ian Wyatt

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 301

Veröffentlichungsjahr: 2009

Beschreibung

Small-cap stocks, those publicly traded companies with market capitalizations less than $2 billion, can yield significant gains that are impossible to find in larger stocks. They've also proven to be among the most attractive investments after a financial downturn. Unfortunately, information about how to successfully invest in these smaller companies has been hard to find--until now. Author Ian Wyatt is dedicated to helping investors find great companies at bargain prices before Wall Street or Main Street catches on. As the Chief Investment Strategist of SmallCapInvestor.com, he's guided countless individuals in their quest to capture small-cap investing success. Now, with The Small-Cap Investor, Wyatt will help you do the same. Throughout the book, Wyatt clearly outlines his proven investment process and the systems that are involved--detailing eight straightforward steps you need to take to find, research, and analyze small-cap stocks that could put big gains in your portfolio. Page by page, he takes the time to explain the essential criteria involved in picking the right stocks and timing your buy/sell decisions. Topics touched upon include: * Identifying growth trends and market sectors positioned for rapid growth in the years to come * Secrets for finding undiscovered small caps before they are embraced by the financial media and institutional investors * Understanding the fundamentals of a potential investment, including products, services, and management's ability to run the business Along the way, Wyatt not only shows you how to find winners, but also addresses how to avoid losers. This is particularly important for investors who have experienced losses in their portfolios, and are looking to grow their portfolios in the coming years. Many of today's top large-cap companies--from Microsoft to Wal-Mart--all started out small and grew to become dominant forces in their respective industries. Investors who bought these great companies early on profited handsomely. By following Wyatt's guidance, and understanding his strategies for finding winners, you'll have a huge edge over other investors and be in a better position to profit from the exponential growth of the right small-cap companies.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Introduction

CHAPTER 1 - Start Small, Finish Big—Discover Big Profits in Small-Cap Stocks

Small-Cap Investor: Eight-Step Process for Big Profits from Small Stocks

Small Caps as Generators of Growth

An Example of Small-Cap Success

Small-Cap Value Stocks Outperform Large-Cap Growth Stocks

Profitable Small Caps Don’t Always Make Gains on Day One

The Inefficient Market Theory: The Small-Cap Advantage

The Market as an Emotional Being

CHAPTER 2 - Big Ideas for Big Profits

Spotting the Next Big Idea

Expanding Your Search

The Competitive Edge

Spotting Institutional Activity

CHAPTER 3 - Finding Great Small-Cap Stocks

Success Stories from the Past

IPOs Are the Genesis of Small Caps

Spotting Growth Sector Trends

News You Can Use

You’ve Found an Interesting Trend or Company—Now What?

CHAPTER 4 - Understanding and Evaluating Financial Statements

Generally Accepted Accounting Principles and the Basics of Accrual Accounting

Financial Statements Made Simple

Ten Key Metrics to Review in Every Financial Statement

What Exactly Are Earnings?

A Quality Test: Cash Flow Instead of Earnings

Ten Accounting Red Flags

CHAPTER 5 - Financial Projections and Valuations

Understanding Financial Guidance

A Reality Check

Guidance Caveats

Interpreting Analyst Estimates

Companies Play the Earnings Game

Financial Trends for Spotting Promising Small Caps

CHAPTER 6 - Taking the Mystery Out of Technical Analysis and Trading for Quick Profits

Some Technical Basics

Accumulation and Distribution

The Relative Price of a Stock

CHAPTER 7 - Trading Strategies for Successfully Buying and Selling Small-Cap Stocks

Liquidity Considerations with Small-Cap Investing

Risk Tolerance

Risk Awareness, an Essential Attribute

Timing Decisions

Trading Techniques

CHAPTER 8 - Portfolio Diversification and Allocation

Equity Diversification Methods

Diversification Mistakes

Overdiversification

Using Mutual Funds and ETFs to Diversify

Risk Tolerance as a Means for Diversifying Your Portfolio

Asset Allocation Basics

CHAPTER 9 - Buy Small Caps to Grow Your Portfolio

A Track Record of Small-Cap Success

The Key Drivers to Growth

Early Bird Gets the Worm

APPENDIX - SmallCapInvestor.com PRO

Notes

About the Author

Index

Copyright © 2009 by Ian Wyatt. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Wyatt, Ian, 1980-

The small-cap investor : secrets to winning big with small-cap stocks / Ian Wyatt. p. cm.

Includes bibliographical references and index.

eISBN : 978-0-470-53572-1

1. Small capitalization stocks. 2. Investments. I. Title.

HG4971.W93 2010

332.63’22-dc22

2009013306

To Gram and Grandpa Cheney who got me started with investing

Acknowledgments

I want to thank the many people who contributed to this book in varying ways.

Thanks to my wonderfully supportive and loving wife, Carrie. Your constant feedback, critiques, and thorough editing have made this book something I am very proud of. Thank you for investing the time in this project, working with me during the evenings and weekends. And thank you for your endless support in my professional and personal life.

Thanks to my loving parents, Bruce and Carol, for supporting my interest in the stock market from an early age, helping me find great learning experiences, and encouraging me to start my own business, taking the path less taken.

Thanks to my sister, Jocelyn, and brother, Reid, for loaning me money to invest in the stock market, my first childhood experience with leverage.

Thanks to my collaborator on this project, Michael Thomsett. I enjoyed working with you to put together a great book—hopefully the first of many.

I also want to thank all of my colleagues at Business Financial Publishing who contributed to this project. To my editor, Bob Bogda, I’ve learned much from you over the years. To my talented researchers, Benson George and Jason Cimpl, thank you for setting aside your regular jobs to help find the examples that made this book what it is. And thank you to everyone else at my company who allowed me the time to write this book.

IAN WYATT

INTRODUCTION

The Story of a Small-Cap Investor

There is nothing quite as exciting, intoxicating, or rewarding as investing in promising small-cap stocks—those on the path to growth, profits, and big returns for their shareholders. I love investing in small-cap stocks, those publicly traded companies with market capitalizations of less than $2 billion. My favorite and best-performing investments of all time have tended to be the smallest of the small caps, with market capitalization of less than $500 million; these are often called micro caps. I like to discover the unknown stock with great promise and strong fundamentals when nobody else has recognized the potential. And I try to buy growth at value prices.

Many great small-cap stocks go unnoticed by other investors, not only by individuals, but by big institutional investors as well. This book tells you why these stocks are usually overlooked, and shows you how to find the small companies with significant potential for growth and profits. It also shows you how to evaluate these stocks from both a fundamental and a technical perspective so you can determine whether you should buy the stock to begin with, and also when you should buy and sell. Small caps are different than mid- or large-cap stocks in many ways, and can yield significant gains that are impossible to find in larger stocks. Unfortunately, until now there hasn’t been a lot of information about how to successfully invest in these smaller, less known companies. In this book, I share with you my simple system for successfully finding great small-cap stocks for maximum profits.

Contrary to what most people think, small caps as an asset class are relatively safe investments. Over the long term, small caps have outperformed every other class of investments, as I’ll show you in a later chapter. And the fact that these investments outperform over the long term makes them a no-brainer for every portfolio. For investors seeking big long-term gains, small caps should be thought of as the home run hitter, the investments that can really help improve overall portfolio returns from average to extraordinary. While the volatility of an individual small-cap stock can be significant, a diversified portfolio of individual stocks, index funds, or mutual funds is recommended for most investors. I believe small caps have a place in every equity investment portfolio, regardless of your investing time horizon.

Throughout this book, I share my investment process and the systems that are involved, and clearly outline the easy steps you need to take to begin uncovering great small-cap gems today. If you seek growth in your portfolio, small caps offer an effective solution. This book shows you how to not only find the winners, but also how to avoid the losers. This is particularly important for investors who experienced significant losses in the stock market crash of 2008 and are looking to aggressively grow their investment portfolio to make up for early losses.

Many investors are skeptical of investment advice from someone who isn’t a hedge fund or mutual fund manager. But after the recent collapse of many hedge funds, and under-performance of most mutual funds, being a “money manager” doesn’t hold the same prestige that it once did. I often get asked, “If you’re such a great investor, why are you selling your information, strategies, and stock picks to individual investors like me?” This is a valid question.

I have never worked for anyone else, but instead have always chosen to do my own thing and taken the path less traveled. This started with my own freelance web design at age 15; the money I earned was invested in the stock market. I started the web site BizFN.com in 1998 while in high school and built it into a leading investment site with content from dozens of investment experts and financial advisors. I attended college for a year before moving on to pursue my entrepreneurial interests. In 2001, I started my Internet publishing company, Business Financial Publishing, which grew to more than $7 million in annual sales within six years, placing my company at number 185 on the Inc. Magazine 2008 Inc. 500 list of the fastest-growing private companies in the United States. Prominent accounting firm Deloitte and Touche also selected my company as one of its fastest-growth companies, rating Business Financial Publishing number 66 on its Fast 500 list of high growth private companies in 2008. Today more than one million individual investors receive my updates and insights into the stock market every day through my various investment publications and services including SmallCapInvestor.com.

I’ve never been a suit-and-tie type of guy and never wanted to have a boss. While my job may not be as prestigious as that of an investment banker or mutual fund manager, it is perfect for me, giving me complete flexibility to spend my time as I choose. Being the boss and owner of my company also allows me to personally invest in great small-cap stocks, educating individual investors, and sharing my top stock picks with others. In a big investment firm, I simply wouldn’t have the same flexibility. Running my own company satisfies my passion for small-cap stocks and my desire to share my investing strategies that have worked so well for me. I enjoy helping investors successfully buy great companies at bargain prices before Wall Street and Main Street catch on to these success stories.

Let me tell you how I got started investing at a young age. In 1982, when I was two years old, my grandfather gave each of his grandchildren $1,000 of Exxon stock and signed each of us up for the company’s dividend reinvestment plan. Within nine years the shares had appreciated more than 500 percent to $7.50 per share from a split-adjusted $1.20. By age 11, I was sitting on an investment portfolio worth more than $10,000, all in Exxon stock, thanks to my generous grandparents.

On family trips, my parents reminded me that I owned a small piece of every Exxon gas station we passed. While on a family vacation when I was 12, I bought my siblings and cousins ice cream using proceeds from a recent dividend check. No work, and I was able to spend money from the earnings of my investment. This ownership concept sparked my interest in stocks and investments. Before my 12th birthday, my parents helped me set up a discount brokerage account at Charles Schwab.

After liquidating half of my Exxon position, I started having some fun buying more stocks. Some of my first purchases were unknown small caps, including a Midwestern radio media company, a maker of stereo speakers, and a chemicals company. I also bought better-known companies whose brands I was familiar with, like the baseball card company Topps and the candy company Tootsie Roll.

One of my best purchases was a company named Fastenal (Nasdaq: FAST), based in Winona, Minnesota. As an aspiring entrepreneur whose business pursuits included a paper route, I was lucky to deliver the daily newspaper and become friends with Bob, a financial advisor at Robert W. Baird, a Milwaukee-based full-service brokerage firm and the first broker to cover Fastenal. Bob turned me on to this unknown small-cap gem, and together we rode the stock for years and enjoyed lavish gains and consistent profits.

Fastenal was a leading seller of industrial and construction materials, including screws, nuts, and bolts. In the mid-1990s, the company was reporting consistent growth. This was far from a sexy business or a company that was of interest to kids in America; it wasn’t Six Flags, Disney, Coke, or Wrigley’s.

But Fastenal was a cash machine. And the stock price soared as the company expanded across the country. I began buying the stock in 1993 around a split-adjusted price of $2.50. In 1992, the company’s sales were $81.3 million and earnings were $8.8 million. A decade later, the stock price was around $17, and the company was a booming success, with sales of $905 million and earnings of $75 million. Who knew the boring business of nuts and bolts could be so profitable? By the time I cashed out of Fastenal in the late 1990s, my gains were more than 500 percent.

Shares were trading at $36 by the beginning of 2008. Had I continued to hold shares of Fastenal in my portfolio, I would have been sitting on even more impressive gains of 1,340 percent! It is difficult to time the peak price of a stock, and almost impossible to sell at the market top (or buy at the market bottom, for that matter). The key point is that only by selling a stock will you be able to lock in profits. Many investments rise and fall in price, and the prudent investors who make money are those that are willing to sell winners and lock in profits, even though the investment may continue an upward trajectory. But selling out too early can be a common mistake of individual investors. It is important to actively monitor and review every investment in a portfolio, and it is okay to continue to hold winners so long as the investment thesis and fundamentals hold up. At the same time, locking in profits along the way is a good approach to take, even if that means selling only a portion of an investment.

After my Fastenal experience, I was hooked on small caps. Nowhere else could I find stocks capable of such impressive movements in a short period of time. Large-cap stocks just couldn’t make such big moves so quickly. How many large caps can gain 500 percent in a few short years? I realized that with small-cap stocks, with a lot of research and a little luck, I could find great undiscovered stocks that were being overlooked by big institutional investors and analysts.

During the 1990s, as a kid growing up in Beloit, Wisconsin, I bought and sold positions in several stocks, some winners and some losers. I began reading the Wall Street Journal book series on investing, talking with family friends about their investments, and reading Barron’s Weekly. I was hooked on investing, utilizing funds from my paper route and other entrepreneurial pursuits to feed my investing habit. I even spent a summer internship working at the Baird branch office in Beloit and at market-making firm Rock Island Securities on the Chicago Stock Exchange to learn more about the stock market from professional asset managers and traders.

I had become an investing junkie by age 15. I spent much of my free time reading books about the investing greats like Warren Buffett and Peter Lynch, digesting investment magazines, reading annual reports from public companies, and digging through press releases and financial information on my dial-up Internet connection at home. I also began reading and participating in online message boards, sharing my opinions with other investors.

I’ve been an active investor for nearly two-thirds of my life, and as of 2009 I hadn’t yet hit age 30. I’ve been through the dot-com boom of the late 1990s, and the subsequent bust of 2000. I’ve seen oil soar from $23 a barrel in 2001 to $147 in July 2008, before collapsing to $35 a barrel by the end of the same year. I’ve seen housing prices (and the share prices of home builders and mortgage companies) jump in the first half of this decade, only to plunge as bad subprime mortgages and poor lending practices tore apart the housing sector and brought the global economy to a screeching halt. During these years, small-cap stocks as a whole fluctuated greatly as measured by the Russell 2000, the index fund serving as the barometer for small-cap stocks. But the thing about small-cap stocks is that there are always winners, in good markets and bad.

There is no shortage of young, innovative public companies doing things differently, and overcoming the challenges facing our society through new solutions, products, and services. This has been true in the two decades that I have been investing and for many decades before that. And it will be true for decades to come.

All of the great large-cap companies that we consider the epitome of success started out as small-cap stocks at some point. Cisco, Dell, Microsoft, and Wal-Mart are the all-time success stories of the stock market. All started small and grew to become the behemoths that they are today. And the early investors who bought these great companies in their infancy stood to profit handsomely as these companies continued to expand year after year.

Every investor I speak with has a story of the small-cap-turned-giant-success that they missed buying, the one that got away.

One of the best reasons to buy small-cap stocks is because others cannot. Most mutual funds and hedge funds simply won’t include these stocks in their portfolios. These funds have too much capital to invest, and small-cap stocks are too small for them to purchase without bidding up the share prices or taking on a position that would result in too much exposure to a single company. It isn’t that these fund managers dislike small caps; in fact, many of them find these stocks attractive, but they are just too small.

A typical mutual fund might hold 100 stocks in its portfolio. If the fund has $1 billion under management, that translates to an average position of $10 million per stock. In small-cap land, a $10 million position is pretty significant. That translates into a 5 percent stake in a company with a $200 million market cap. Not only is this a large portion of the pie; it also takes too long to buy or sell that much stock, perhaps several months. Because small caps are unknown and there are fewer shares outstanding, share volume in the market is also small. Therefore, the fund can’t just go out and buy or sell millions of dollars in stock in a few days. It takes time to build and liquidate positions, increasing the risk for these funds.

Instead of investing in small caps, funds focus on the larger companies mentioned on CNBC and Fox Business News every day, written about in the Wall Street Journal, Fortune, and Forbes, and constantly discussed on Internet message boards and blogs. They’ll start buying up the most popular small caps once they have proven themselves and are on the verge of going to mid- or large-cap status, but by then the major profits have already been made by the astute early-stage investors.

This reality points out a problem and also an opportunity. Consider the case of 2008. The financial crisis that year wreaked havoc on the stock market, and caused billions of dollars in losses for investors and future retirees in the United States and around the world. My portfolio also took a beating, especially since I previously owned some index funds for diversification purposes in my retirement accounts, including the Russell 2000 and Russell Micro Cap. These indices track the movements of small- and micro-cap stocks, and their values cratered in 2008, along with all of the other major indices. While some great companies suffered in that economic environment, even those with strong earnings and bright prospects saw their share prices drop significantly as investors sold everything, including the good, the bad, and the ugly.

Small cap stocks took a beating along with every other class of equities. Stocks were trading at rock-bottom prices based on price-to-earnings ratios. The P/E ratio—price per share divided by earnings per share—is one of the most important measures of a company’s earning trend over time. I will explain this in detail in a coming chapter. With the Russell 2000 index of small-cap stocks plunging 60 percent from October 2007 to March of 2009, value investors argued that the decline in stocks had created a “generational low” price for stocks, and a buying opportunity for brave investors.

Investors benefit by focusing on growth when markets have fallen. Buying municipal bonds, T-bills, and other conservative debt instruments will not bring an investment portfolio back from the brink of extinction. It may preserve capital, but it won’t make up for significant losses. To recover, you need to take an intelligent equity-based approach.

Small caps benefit a portfolio and can be represented in every diversified portfolio hoping to generate capital gains. History has shown that small-cap stocks are among the most attractive investments after a financial downturn.

The great small caps, the ones I will show you how to find, are agile, opportunistic businesses that thrive in good times and bad. These companies and their leaders seize upon opportunities to create profits regardless of the environment. They have fewer employees, smaller overhead, greater financial incentives for their employees, and aren’t burdened by big pension plans, like those of General Motors, that weigh on the entire company. Given their nimble nature, small caps can retool and address market opportunities more quickly and efficiently than larger behemoths that take forever to make even small changes. These are the companies that I seek to buy and the ones that will perform best over time.

I love to take risks. This should come as no surprise. I’ve always been a risk taker with my entrepreneurial companies and my investments. My game in Las Vegas is blackjack. I can sit for hours at a card table, watching the cards and making value judgments about my odds. I find that small-cap investing can be as fun as blackjack in Vegas, but your odds are much better if you do your homework. Playing blackjack, the casino has an average of 0.5 percent edge (varying by the number of decks being used) if the player is using basic strategy. That makes blackjack the most profitable of all Las Vegas games for the player, and if you vary your bets properly, you can even win occasionally.

With small-cap stocks, your advantage of winning is even better, as are the profits from those winning positions. By using my methodical process to pick stocks and time buy and sell decisions, you’ll have a huge edge over other investors and book major profits. In blackjack, a typical winning hand results in a payout equal to your bet, or the equivalent of a 100 percent return. But with stocks, the upside potential is much greater.

My goal with this book is to help you find the next great small-cap stock that could become the Cisco, Dell, Microsoft, or Wal-Mart of tomorrow. None of these large-cap companies will see their shares multiply by a factor of 10 in the next decade. But dozens of small-cap stocks will see their shares achieve 10-bagger status, to borrow Peter Lynch’s term for stocks that appreciate by +1,000 percent.

I believe in my own process and use it every day. I am going to show you how to find the next unknown sleeper that could become your own goldmine.

CHAPTER 1

Start Small, Finish Big—Discover Big Profits in Small-Cap Stocks

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50 percent a year on $1 million. No, I know I could. I guarantee that.

The universe I can’t play in has become more attractive than the universeI can play in. I have to look for elephants. It may be that the elephants arenot as attractive as the mosquitoes. But that is the universe I must live in.”

—Warren Buffett, 1999, discussing small-cap stocks

An old saying claims that big shots are the little shots who just keep shooting.

In the case of the stock market—in particular, the world of small-cap stocks—that maxim is decidedly true. And that is terrific news for you. Over the last decade, I’ve developed a system for consistently finding outstanding small-cap stocks that deliver big gains to early investors. Throughout this book, I’ll share everything you need to know to achieve similar results in your own investment portfolio.

All great companies start out small. They are built by entrepreneurs who invest their time and money, raise capital privately, and turn their dreams into reality. Many of the world’s greatest innovations come from small, entrepreneurial companies, and very few come from the behemoths. In recent decades, smaller companies have increasingly been investing in research and development, helping fuel the growth of the overall economy. To illustrate: In 1981, 71 percent of corporate research and development dollars in the United States was spent by companies with more than 25,000 employees, while companies with fewer than 1,000 employees spent just 4 percent. By 2006, the large companies’ share had dropped to 38 percent, while the small companies’ share had risen to 23.7 percent; it is a trend that has continued to shift.1

Why? Charles Matthews, executive director of the Center for Entrepreneurship Education and Research at the University of Cincinnati, has observed that smaller firms historically employ a large percentage of computer analysts, engineers, and scientists. This drives an interest in innovation and research; today, most new jobs are generated among small companies, where the growth rate is going to be rapid in comparison to their larger competitors.

Small businesses are excellent incubators of innovation, especially technology-driven innovation. With generally flatter organizational structures, these leaner, hungrier companies can cut through the red tape, remain focused, and drive innovation with passion and efficiency.

The best of these young, innovative companies become publicly traded small-cap stocks. This allows individual investors like you to buy a piece of the action, and participate in the future growth and profits of these companies.

Small-Cap Investor: Eight-Step Process for Big Profits from Small Stocks

Throughout this book, I share with you my eight-step system for finding great small-cap stocks with big potential for financial out-performance and share price gains. I will show you exactly what you need to do to become a small-cap guru and profitable investor in small-cap stocks.

There are eight simple steps to follow in order to find, research, and analyze small-cap stocks that could put big gains in your portfolio.

Step 1:Growth Trends: Identify growth trends and market sectors positioned for rapid growth in the years to come.

Step 2:Finding Potential Winners: Screen more than 7,000 publicly traded companies to find those companies that are unknown performers positioned to grow.

Step 3:Fundamentals Matter: Understand the fundamentals of the potential investment, including products, services, and management’s ability to run the business.

Step 4:Financial Performance: Review and evaluate key metrics in a company’s financial statements to understand historical financial performance.

Step 5:Earnings Quality: Look for red flags that indicate financial manipulation or fraud to avoid investing in a small-cap lemon.

Step 6:Growth Outlook: Develop an understanding of expectations for growth to make valid valuation comparisons.

Step 7:Technical Analysis: Understand the technical indicators of share price movements to help timing of investments, and maximize profits while limiting losses.

Step 8:Pulling the Trigger: Determine the optimal timing for entering new positions by using effective trading strategies.

Using my system for finding, researching, analyzing, and ultimately buying and selling small-cap stocks will make it easy for you to find those companies with huge potential upside, and determine when and how to maximize your profits.

Throughout the book, I show you exactly how to use these eight simple steps for consistently finding and profiting from great small-cap stocks before their shares take off.

Small Caps as Generators of Growth

Many of the smaller, innovative growth companies that are publicly traded fit the definition of small caps. Market capitalization is a measure of the total value of a company, calculated by multiplying shares outstanding by share price. As the term “small cap” suggests, these are the smaller companies, those with a market capitalization below $2 billion (mid caps range in size between $2 billion and $10 billion, and large caps are those with market caps exceeding $10 billion).

On my investment website, SmallCapInvestor.com, I focus on the small-cap stocks with market capitalization below $2 billion, and often those below $500 million. It is often the case that the smaller the better when trying to find companies poised to deliver big gains. Table 1.1 shows a list of the 10 best performing stocks and their returns for the decade ending December 31, 2007.

The returns are impressive. But look at the market capitalizations of these companies in 1998; nearly all of them are below $100 million. The smallest of the small caps tend to perform best—those unknown gems that have not yet become the darlings of Wall Street.

How many of these companies had you heard of in 1998, or even today after their significant growth? With the exception of Apple, probably not many. This is because most of the best small-cap opportunities are not well known today, and the key is to find them right before they become huge successes and their shares have risen significantly. This is the challenge.

TABLE 1.1 Top 10 Best Performing Stocks: 1998-2007

Source: Capital IQ, www.capitaliq.com

What is most appealing about small-cap stocks? There are a number of attributes. An investment-worthy small cap is often a young company experiencing its fastest period of growth. The company introduces new products or services, launches strategic partnerships, or enters a new market while still flying under the radar of its larger competitors, remaining unnoticed by Wall Street analysts and investors. With fewer employees and lower expenses compared with larger companies, small caps have the unrestrained flexibility to pursue growth and have the ability and desire to take risks that are often avoided by the dominant industry players. This situation can catapult a small, unknown company into a roaring success, and in doing so, create millionaires out of early shareholders who stay the course.

Want proof? Let’s examine a few examples of some of the best performing stocks in the history of the stock market. While I’m sure you’re familiar with each of these companies, perhaps you are less aware that all started as entrepreneurial, small-cap companies that grew into well-known businesses, making big gains for early investors:

• Cisco Systems (Nasdaq: CSCO): An investment of $10,000 in 1990 grew to $34.5 million by 2008, a gain of over 34,000 percent. The company’s IPO valued the tech company at $224 million, and 18 years later the company was valued at $180 billion. The reason that Cisco has grown in an explosive arc is due to yet another trend identified early and ridden from there on: computer networking. The brainchild of husband and wife Len Bosack and Sandy Lerner, the company got its start by developing and selling routers, but not just any other router like those already on the market. Theirs was the first to support multiple network protocols; although that technology was eventually supplanted, Cisco had its foothold. The company later branched out with careful insight, moving into Ethernet, switching, security, ATM networking, and other areas. Although Cisco was, in fact, the most valuable company in the world at the peak of the dot-com boom of the late 1990s and into the early 21st Century, it has since declined in value but remains one of the icons of the American technology community.

• Dell (Nasdaq: DELL): went public in June 1988 as a small-cap valued at $200 million. As of the end of 2008, market cap was more than $20 billion. An investment of $10,000 in June 1988 grew to $2.8 million in 20 years. Why the meteoric rise? The most revolutionary aspect of Dell’s operation was its direct sales marketing strategy. Rather than using re-sellers to sell its products, Dell established a one-on-one relationship with its customers. But that meant more than just direct selling. It spelled the beginning of a highly personal form of interaction with Dell customers. For instance, in 1985 Dell began establishing customer service as the bedrock of the company’s philosophy and approach, offering a risk-free return policy and next day in-home professional support. Three years later, Dell raised $30 million in its initial public offering, and the company was off and running.

• Microsoft (Nasdaq: MSFT): An investment of $10,000 in 1986 was worth $3.4 million by 2008, as the company’s market capitalization soared from $488 million at the time of its IPO to over $200 billion. An idea whose time had come—the personal computer in every household—quickly established Microsoft as the premier provider of user-friendly software. Although the company is now synonymous with its line of Windows products, its first real commercial success derived from its DOS operating systems (remember those?). Microsoft beat out IBM because its Windows system was simply easier to use—in fact, much easier. The company debuted in the public market with a share price of $21. Thanks to these and other innovations, by December 1999 the price per share (adjusted for stock splits) topped over $17,000.

• Wal-Mart (NYSE: WMT): An investment of $10,000 in 1972 was worth $7.61 million by 2008. Like other small companies that blossomed, Wal-Mart captured and leveraged a revolutionary idea—in Wal-Mart’s case, discount retailing. The company went public with a market capitalization of only $21 million, and it was worth $200 billion by 2008. Prior to opening his first store in Rogers, Arkansas, in 1962, Sam Walton exhaustively researched the prevailing consumer market and determined that shoppers could live better by saving on a broad variety of goods and products. For Walton, that was in large part a bottom-up proposition; as the company grew, Walton still tried to visit each store at least once a year, asking employees for their input and singular perspective of what consumers wanted and valued most. (This direct market research style is employed by Starbucks founder Howard Schultz and other retail executives.)

Although Wal-Mart has come under fire for labor practices and other issues, its success is undeniable. By 2009, 7,390 Wal-Mart stores (and its adjunct Sam’s Club operations) were open for business, employing more than two million people and making the company the largest retailer and private employer in the world.