Big Winners for Small Investors

A well-known investor once claimed he could earn you 50% per year on a portfolio of ordinary common stocks. Of course, there was a condition.

Or maybe that's an urban legend. After all, folks have argued the point for years. But what if this guy really did make that claim? And if so, what was that one condition?

Enter a flock of Jayhawks
While we bickered over who said what and when, a bunch of schoolkids did something about it. They kicked their way across Kansas and demanded a chat with this gentleman.

When he agreed, they simply asked him: Did the guy commonly known as the world's greatest investor ever really make that "50% per year" guarantee?

And, more importantly, would he stand by it today? As it turns out, this fellow didn't just confirm it was all true -- he went one step further.

You'll be surprised how he would do it
To earn you 50% per year -- essentially doubling your money every 20.5 months -- he wouldn't buy the blue-chip consumer giants like American Express (NYSE: AXP) that made him a legend, or even his own $200 billion company.

No, he'd buy obscure companies with names you've never even heard. How do I know that? He told us. Remember that one condition I mentioned earlier?

Well, this guy would guarantee that 50% per year ... only if he had less than $1 million to invest. That's because he would invest in undiscovered, thinly traded small companies -- the one niche in the market where individual investors like us have an advantage over the pros.

Why Warren Buffett wishes he were you
I imagine you guessed it was Buffett. Well, can you guess why he wishes he were you? Because he has too much money. Yeah, I know that sounds nuts. After all, the big money on Wall Street has all the advantages, right? Wrong.

For one thing, most pros have way more than $1 million to put to work, so they can't mess with a little satellite equipment maker like Comtech Telecommunications. Well, maybe they can now -- but not 10 years ago when Comtech started the 4,000% run-up that made it one of the market's 10 best stocks.

That's one big reason you see so much trading volume in the usual suspects. Don’t believe? Take a look at these names among the most heavily traded Nasdaq stocks.

And over on the NYSE? How about EMC (NYSE: EMC) and Pfizer, trading 35 million and 43 million shares a day, respectively. On Wall Street, they call this liquidity. I call it a polite way of saying "the good old boys buying and selling the same old stocks to each other."

Either way, if you've got half a billion to put to work this afternoon, you'd better buy one of those and forget the next big thing. But don't expect to be dazzled -- the usual suspects don't have many doubles left in the tank, much less one every 20 months or so.

Wait a minute! Aren't small companies risky?
Not necessarily. Ibbotson Associates tracks stock returns by "style" and market cap. You could have invested $1,000 in Ibbotson's large-cap universe back in 1927, and you'd have about $2 million today. Not bad.

If you'd bought small-cap value stocks instead, you'd have $33 million. Of course, that's a long time to be invested. But then, isn't that the point? Of course, the word "value" is critical, too. In fact, combining small-cap potential with old-school valuation may be the missing link between big profit potential and Buffett's 50% boast.

Motley Fool co-founder Tom Gardner hammered this lesson into my head back when I worked with him on The Motley Fool's Motley Fool Hidden Gems newsletter. So I know firsthand how fantastic the returns can be when you focus on unloved, obscure, and (most importantly) underpriced small companies.

No, stocks aren’t dead!
Don't be fooled. The financial crisis will pass -- the shenanigans in Washington notwithstanding. More important, this is a rare opportunity for investors like us. Many great small businesses with rock-solid balance sheets are on sale by no fault of their own. And when the economy turns, great small companies will lead the way, like they always do.

Copyright © 2008 Universal Press Syndicate.