Profits in Plain Sight

By Roger Friedman (TMF Roger)

Before I came to work at the Fool, I always assumed that a search for little-known companies would require me to scour society's unloved underbelly, searching in dark crevices for the company that makes luxury nose-hair trimmers or develops the little magnetic strips on credit cards or manufactures the crayon sharpener in the big pack. Little companies that do little things.

But it turns out that in the quest for the small companies that will someday turn into really big companies -- the next Wal-Mart or Microsoft or Starbucks or whatever -- we aren't limited to operations that are running out of someone's garage. With a market cap range of $200 million to $2 billion for formal recommendations in the Hidden Gems newsletter service, there's an incredible variety of "real" companies to pursue in the hopes of finding one (or a few) that will provide market-thumping returns as they grow.

Right now, these companies are mostly underfollowed by analysts, undervalued by investors, and flying comfortably beneath Wall Street's radar. But we don't necessarily have to troll the waters of obscurity to find small-cap winners. There are plenty of businesses valued under $2 billion that are well-run and shareholder-friendly, that are increasing sales at least 15% annually -- and that I've heard of! So I get to combine the potential magic of small-cap investing with Peter Lynch's commonsense brilliance of buying what I know.

A quick screen turned up quite a few promising prospects.

A bouquet of well-known small caps

You've been there before. Your anniversary is somehow -- completely without warning -- tomorrow and you need to prove that you were not only aware, but anticipating the event. So you make a quick call to 1-800-Flowers (Nasdaq: FLWS) to maintain your status as a good guy. The $400 million flower delivery company expects to continue 15% growth in year-over-year sales, boost its margins by 1.5%, and generate about $25 million in free cash flow. Although 1-800-Flowers has yet to be a compelling investment, this is a well-known brand with substantial sales growth. If management figures out a way to start turning consistent profits, this could be a small-cap story worth watching.

Later, when you finally realize that there are ways to remember anniversaries and birthdays, you key those big days into your Treo, the do-everything machine from Palm (Nasdaq: PALM). According to a post from community member hiddenflem on the Hidden Gems discussion boards:

"Last month, longtime rivals Microsoft (Nasdaq: MSFT) and Palm announced that the new Palm Treo will run on Windows Mobile 5.0 and will use the Verizon (NYSE: VZ) EVDO network.

"Is this for real? Yes, it's for real, and we can only marvel at the prospect. Old rivals Microsoft and Palm are an unlikely, but welcome pairing. Palm's very popular Treo smartphone, coupled with Microsoft's mobile OS -- with its myriad multimedia capabilities running over Verizon's high-speed wireless broadband network -- is a compelling combination. ... The new Treo smartphone bodes well for corporate and consumer users. They will be getting the best of the best. Microsoft has had limited success with its Windows Mobile OS and has not been hugely successful in the PDA market. And Palm's decision to support Windows Mobile 5.0 on its device is a clear nod to Microsoft's continued dominance of the desktop operating space. It makes absolute sense that the firms would combine these two best-of-breed products into a single offering."

And yes, with a market cap of $1.4 billion, Palm is a small-cap company (although its omnipresent technology might lead you to believe it's already much, much bigger).

Small caps for your progeny

If you have a kid in college, you are most likely aware of Blackboard (Nasdaq: BBBB) -- you probably write a check to cover the cost of it every semester. The company's Academic Suite helps professors and students interact by sharing syllabi, homework assignments, grades, and cooperative research online. As Motley Fool co-founder Tom Gardner wrote in his recommendation of the company in Hidden Gems, "Blackboard has more than 3,000 licenses with 2,225 institutions, serving students from kindergarten through graduate school. The average licensee pays close to $29,000 a year, and customers are renewing at a rate north of 90%. The firm is making inroads internationally, with more than 15% of its sales on foreign soil and a commitment to translate its software into eight languages by the end of this year." Moreover, the company just bought its largest competitor. Yup, another small-cap company -- $800 million for now.

OK, one more. Parents of younger kids are not only aware of LeapFrog Enterprises (NYSE: LF), but their homes may well be overrun with its electronic learning toys for toddlers to teens. The Hug & Learn Baby Tad Plush is a constant companion for my daughter -- so much so that she felt compelled to put a diaper on him. The toy maker recently released a pen computer -- featuring an optical scanner and a computer chip -- that could substantially broaden its scope and success. The $99 gadget hit retail stores in October. One trick it can perform: If you draw a musical instrument, the pen's speaker allows you to play it. Hasbro and Mattel (NYSE: MAT) remain the clear leaders in the toy kingdom, but more hot products like the FLY pen computer and the LeapPad could transform the $900 million LeapFrog into a company worth closer to the $3.5 billion and $6.5 billion that Hasbro and Mattel command -- making it a potential four- to seven-bagger.

There are thousands of smaller companies that want to make the leap into the realm of the big boys, both hidden and obvious. Fool co-founder Tom Gardner offers up two great options every month in Hidden Gems, and with a free, no-obligation 30-day trial, you get access to each one of his selections since the newsletter's inception. (To date, those recommendations are besting the S&P 500 by more than 20 percentage points.) Take a look and find the best companies you've never heard of and the best little companies you thought had already made it big.