IE 11 is not supported. For an optimal experience visit our site on another browser.

Be a Penny Stock Millionaire!

The story of Wal-Mart's rise from a $21.5 million capitalization.
/ Source: Motley Fool

Our goal at Motley Fool Hidden Gems is to find the best small companies to own for the next three to 35 years. It's a wonderful aim, since historical data illustrates that small-cap stocks -- particularly of the value variety -- have substantially outperformed the overall market for the past 40 years.

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 of a century or more.

The best time to sell shares of a truly superior small company is almost never. Selling Hewlett-Packard (NYSE: HPQ) or ExxonMobil (NYSE: XOM) in the early days after doubling your money would have wound up costing you dearly. Even considering recent market woes, both have greatly rewarded shareholders as the years rolled by.

It's been more than six years, and our Hidden Gems recommendations have easily topped the S&P 500, even through all of the market turmoil. There's no question that we'll have down periods. Recessions can be nasty for small-company stocks. But, over time, we expect to continue 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 at Hidden Gems, they are a minority of our selections. Instead, we favor sleepy and underfollowed companies with high-quality management.

For the ultimate example, think Wal-Mart.

In November 1980, Wal-Mart was trading at a split- and dividend-adjusted $0.18 per share. That's right, 18 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 of 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 20-cent stocks. You won't.

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

With the stock trading near $50 as of this writing, it has returned 275 times in value in the past 29 years. A $5,000 investment back then is worth more than $1.3 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, when it became a public company in October 1970? The business was valued at a tiny $21.5 million then. That means the stock is up roughly 100,000% since.

When the company went public, it raised $4.5 million in cash to pay down debts. Wal-Mart was nothing back then. No one knew about it. Hardly anyone followed it, while dozens flocked to established giants such as Eastman Kodak (NYSE: EK) and Xerox (NYSE: XRX) -- "safe bets" that have frustrated loyal shareholders for decades. 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 intentionally 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. You'll see this in many other solid performers over the decades, like Pfizer (NYSE: PFE).
  • Related to that point, its dividend started in the teeth of a bear market in the early 1970s. That said a lot about the strength of its financials.
  • For years, no analysts followed it.
  • For years and years, institutional ownership was well below 50%. 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 went public.

Find the next one
We're not trying to reinvent the wheel here at Hidden Gems, because 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 on the past 25 years. The Internet makes much of the research relatively quick and easy.

We also have 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, we can do a lot 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 $500 million. We see the incredible long-term outperformance in the charts for Altria (NYSE: MO) and Johnson & Johnson (NYSE: JNJ), and we study their history. We have no doubt that we'll find some of the market's major winners for the next three to 35 years. Panning for tomorrow's winners is our full-time work and mission statement.

If you'd like full access to our service for a trial run of 30 days, let us know. It's free, and there's no obligation. You can see all our investment recommendations -- including the top five stocks for new money now -- in our search for the next Wal-Mart-like winner.

This article was originally published on Dec. 17, 2004. It has been updated.

Rex Mooreis ready for a Wally World road trip, and contributes the Foolish 8 screens to Hidden Gems. He owns shares of Johnson & Johnson. Wal-Mart and Pfizer are Motley Fool Inside Value selections. Johnson & Johnson is an Income Investor recommendation. The Motley Fool is investors writing for investors.