Wall Street analysts do a great job researching and following big, widely held, and actively traded companies such as Advanced Micro Devices (NYSE: AMD ) , XTO Energy (NYSE: XTO ) , and Forest Laboratories (NYSE: FRX ) . That's their job, after all, and 20 or more sell-side analysts follow each one of these names.
You can't blame them for this big-company bias. Those are the stocks that give their firms the most business in both banking and trading departments.
And while big companies are an integral part of any portfolio, they aren't the stocks individual investors like you and I can buy to generate the highest possible returns.
From the horse's mouth
In his recent book, Full of Bull, former Wall Street tech analyst Stephen T. McClellan says individual investors can take advantage of the fact that "analysts miss titanic secular shifts." He explains:
Analysts rarely take seriously the emerging companies that are pioneering a new wave. ... They fail to give proper credence to up and coming companies that represent a disruptive market leapfrog. ... Because the status quo is easier, they often miss the boat when a new force emerges.
McClellan tells the tale of how he discounted Microsoft in the 1980s because he thought it was no different than other startup software companies of the time, such as Lotus and Borland. "I paid the price for my oversight," he says bluntly.
Another case of expensive oversight
A more recent example of analyst oversight is the medical-device industry circa 2005. While entrenched stalwarts such as Zimmer (NYSE: ZMH ) and Smith & Nephew (NYSE: SNN ) got the coverage, a small robotic surgical equipment company, Intuitive Surgical, was showing signs of promise. Its revenue grew 51% in 2004; it held a near-monopoly in its market niche; and its breakthrough minimally invasive surgical technology was gaining favor among doctors and patients.
Granted, you would have subjected your savings to greater volatility with Intuitive Surgical, and there wasn't (and still isn't) a lot of analyst coverage on it, so you would have had to do a lot of your own research. Taking the "safe" route by investing in larger medical-device companies might have seemed more attractive on a risk-reward basis.
The foresight and extra research, however, would have paid off. Over the past three years, Zimmer and Smith & Nephew have made minimal gains, while Intuitive Surgical has returned more than 80% annually.
Leave your comfort zone
Looking for the next ultimate growth stock among those the Street has already discovered is futile. By the time analysts catch on to a revolutionary company, the jig is usually up.
The problem for individual investors is finding these industry-changing (sometimes world-changing) companies before Wall Street does. Fool co-founder David Gardner and his Motley Fool Rule Breakers team have made it their mission to find these stocks early on and ride them to tremendous returns.
In fact, they first recommended Intuitive Surgical to subscribers in March 2005. They said, "The company is only lightly followed by Wall Street -- just four analysts cover it -- so we have the advantage of getting in before the crowds. We expect the company's future performance to be about as subtle as a brick through a window."
A brick through a window indeed -- that pick has since returned nearly 540% for Rule Breakers subscribers.
If you need help finding tomorrow's big winners, you can get a full-access, 30-day trial of Rule Breakers, free of charge. There's no obligation to subscribe. Just click here to get started.
This article was first published Feb. 25, 2008. It has been updated.
Fool contributor Todd Wenning does not endorse throwing bricks through windows, except in the metaphorical sense. He does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value pick. The Fool's disclosure policy is groundbreaking.