Be a Penny Stock Millionaire!

January 22, 2009 4:23 AM ET

To optimize our returns, we look to sell our mistakes quickly, hold sound companies for an average of three years, and then, yes, maintain our stakes in the very best of the lot for a quarter-century or more. The best time to sell shares of a truly superior small company is almost never. Selling Rohm & Haas (NYSE: ROH) or Home Depot (NYSE: HD) in the early days after doubling your money would have wound up costing you dearly, since both continued to crush the market as the years rolled by -- despite the recent market woes.

It's been more than five years, and our Hidden Gems cumulative returns thus far are gratifying despite a horrendous recent small-cap market. Our recommendations are beating the S&P 500 by an average of five percentage points each. There's no question that we'll have down periods. Recessions can be nasty for small-company stocks. But over time, we expect to outperform the general market by buying and holding onto the next wave of great American companies.

How do we find them? Think Wal-Mart.
One way to find the future greats is to carefully study the major winners from the past. Relatively few of the multidecade superstars are technology companies. And while we don't avoid tech stocks in Hidden Gems, they are a minority of our selections since we instead favor unloved or underfollowed companies with high-quality management. Our sleepy, boring successes thus far include commercial-oven maker Middleby. But for the ultimate example, think Wal-Mart (NYSE: WMT).

In November 1980, Wal-Mart was trading at a split- and dividend-adjusted $0.16 per share. That's right, 16 cents. But let's be clear: The stock was selling at $50 per share then, so it was never a penny stock. We think it's nearly impossible to become a penny stock millionaire -- despite the mischievous title we placed on this article. No, the greatest stocks are those of real companies with real earnings. Because of stock splits, some investors think you'll find the next Wally World while searching among 16-cent stocks. You won't.

So what has Wal-Mart done since 1980, a full decade after it went public?

With the stock trading at $50 as of this writing, it has multiplied more than 300 times in value over the past 28-plus years. A $5,000 investment back then is worth nearly $1.6 million today. That'll clean up a lot of investment mistakes!

But what if we go all the way back to Wal-Mart's IPO in October 1970? The business was valued at a tiny $21.5 million then. That means the stock is up roughly 10,500 times since. That's 28% growth per year, and it would have turned a $5,000 investment into nearly $53 million today.

When the company went public, it raised $4.5 million in cash to pay down debts. No one knew about it. While dozens of analysts flocked to names like General Electric (NYSE: GE) and U.S. Steel (NYSE: X), Wal-Mart was nothing back then, and none of the big boys on Wall Street really cared about it. And that plays right into Hidden Gems' sweet spot.

Reverse-engineering a superstar
Now it's time to pick out the qualities of what has been one of the greatest 25-year investments in the history of our species. Here are the traits of Wal-Mart in its early days -- traits that we look for in Hidden Gems:

• After just a few years in the public markets, it began paying a dividend and never stopped -- amazing for such a tiny company.
• What's more, its dividend stared into the teeth of a bear market in the early 1970s -- a telling sign of the strength of its financials, given the trying times.
• Wall Street treated the company like it was made up of a bunch of Arkansas hillbillies. For years, no analysts followed it.
• Institutional ownership was well below 50% for years and years. As we said, hardly anyone cared.
• Sam Walton owned the majority of the stock. Here was a founder with a stake in the organization's enduring success.
• Its concept was new and innovative, yet proven. Wal-Mart had been in business for eight years before going public, with more than 30 stores and more than $32 million in sales on the day of its IPO.
• It had a compelling valuation, trading at just 0.67 times sales when it came public.

Find the next one
We're not trying to reinvent the wheel here at Hidden Gems -- we simply don't need to. There's something on the order of 100 years of researchable history of the U.S. stock markets, and tons of data available over the past 25 years. The Internet makes much of the research relatively quick and easy.

There are also numerous masters who have shared fully formed ideas on how to earn extraordinary returns in small caps -- from Peter Lynch to Charles Royce to Warren Buffett to Martin Whitman. By combining our research capabilities with the outstanding principles these folks have handed down, there's a lot we can do together to increase your wealth over the long term.

This is the aim of our Hidden Gems community every day, with thousands of members working together and examining the more than 7,000 public companies capitalized at less than $2 billion. We see the early outperformance in the long-term charts for Nike (NYSE: NKE) and McDonald's (NYSE: MCD), and we study their early history. We know that Phil Knight founded Nike, owned a stake in the business, and was committed to building a lasting brand. We know that McDonald's founder Ray Kroc was also devoted to his business and that the cash-generating company declared a dividend just 10 years after going public.

Looking for similar traits, we have no doubt we'll find some of the market's major winners over the next three to 35 years. Panning for these small-cap studs is our full-time work and mission statement.