How to Profit From Wall Street's Wallflowers

Those of you who read our weekly rendition of Donald Trump's self-promoting TV job interview -- that is, The Apprentice -- know I dabble a bit in reality television. My favorite is Extreme Makeover: Home Edition, Sunday nights on Disney's ABC. Other shows have made me curious, of course, such as The Amazing Race and Survivor on Viacom's CBS. Even Richard Branson's The Rebel Billionaire, which appears on News Corp's Fox, got a 15-minstrel trial. Most of the others look either too disgusting, or too silly, to deserve any of my time, including the one that potentially has the best name: The Swan.

The idea behind the show is to turn what Fox's website says are "self-proclaimed ugly ducklings" into beauty pageant contestants through a combination of cosmetic surgery, therapy, and....Oh, you get the picture, right? I doubt I'll ever watch the show, but the concept is intriguing, and, believe it or not, underscores an irrefutable stock market truth.

Some stocks that appear ugly and are unloved by the big mutual fund firms are really swans in disguise. Indeed, this idea is so powerful that Fool co-founder Tom Gardner has taken it to heart in picking winners for Motley Fool Hidden Gems subscribers. But here's the thing, Fool: Even though you'd be a fool not to take us up on our free-trial offer, you don't have to be a part of Gemdom to profit from the wallflowers. A nice suit, a few breath mints, and a good stock screener can get you on your way to dancing with these beauties while they're still ugly ducklings.

Sorry, pal, everyone has a partner already
There's a neat statistic you can find for any stock through Yahoo! Finance. Enter any ticker symbol at the top of the page and you'll get a quote, but if you use the navigation bar at the left, under the subhead "Company," you'll find a link for "key statistics." Click that, and you can find out how much of the stock is owned by Wall Street's big institutions, such as mutual funds.

As you might imagine, the popular stocks, like the popular kids, were dating long before showing up to the stock market's dance party. Take white-hot Apple Computer (NASDAQ:AAPL), for example. More than 70% of the outstanding stock in the iPod people is owned by institutions. It's as if mutual fund managers are elbowing each other for the chance to shimmy with Apple CEO Steve Jobs.

But, believe it or not, Apple isn't among the princes or princesses of this prom. Nope, that honor goes to the 30 companies that comprise the Dow Jones Industrial Average. Giants such as General Motors (NYSE:GM) routinely sport institutional ownership in excess of 70%, with only a few exceptions, such as Apple rival Microsoft (NASDAQ:MSFT). Mr. Softy is living up to Bill Gates' nerdy reputation, with only 54% of its outstanding shares loved by the faithful on Wall Street, according to Yahoo! Finance.

A brief interlude: the efficient market theory
There's an old Wall Street bedtime story that says investors simply can't profit from individual stocks because the market is comprised of investors with perfect information, and thus every stock is valued perfectly. This fable is also known as the efficient market theory. It came to popularity more than 30 years ago with a best-selling book called A Random Walk Down Wall Street, written by Princeton economist Burton Malkiel.

I won't go into the absurdity of this principle because there isn't space in this column. However, it's worth noting that at least the idea makes sense. The market is all based on information and is democratically organized. I'm not supposed to trade on insider information and neither are you. You and I pretty much know all that the general populace can know about big firms such as Microsoft.

So what's the problem? The efficient market theory assumes that investors act intelligently in buying stocks, and that the media and Wall Street's analysts perfectly cover every public company. But that's ridiculous. All you need to do is take a peek at the three-month stock chart for Travelzoo (NASDAQ:TZOO) to understand that this isn't true.

Maybe you oughta go stag to this dance
Is it really any wonder that the Foolish investor just might want to go stag to the stock market dance? Think about it: If Wall Street is always right, and stocks are perfectly priced, then where are the profits? In wallflowers, of course. The unloved. The ignored. The well-disguised princess wearing horned-rimmed glasses and a turtleneck sweater, sitting alone by the punch bowl. She's out there, it's just that so many of us simply don't notice her and her seemingly geeky friends.

So how do you find the budding swans among the ugly ducklings? It's pretty simple, really. Most discount brokers offer stock screeners capable of measuring dozens of characteristics. To find potential swans, we'll start with five:

• Institutional ownership of 40% or lower
• A stock price of at least $5 per share
• A market cap of $250 million or greater
• Net margins above 10%
• A P/E ratio of 15 or less

My screener at Fidelity reveals that -- wow -- more than 150 companies share these characteristics. We can limit the field, though. I mean, really, you don't have to dance with every wallflower. (Seriously, dude, you're not that hard up, are you?)

Let's add a minimum 25% return on equity since we like superior management, and demand that no more than two analysts cover the little quackers. Running the revised screen puts us at seven candidates. Have a look:

With the S&P 500 priced at just under 20 times earnings, according to data provider Barra, any of these stocks could be the life of the party. But don't be fooled. No screen is perfect, and swans are only found through Foolish fundamental research.

For example, dig into the story behind super-cheap GenTek and you'd find the firm entered Chapter 11 bankruptcy a year ago and was selling off business units in March. You might also learn that Knightsbridge Tankers' mouthwatering 10.31% dividend yield hadn't been fully covered by cash flow in 2002, and was barely so the year before. Only in 2003 did the firm generate enough moolah to pay its rich dividend and still have some cash left over to fund future operations.

There are really only two candidates for the swan among these ugly ducklings. IMPAC Mortgage Holdings, a California-based Real Estate Investment Trust (REIT), and Webzen, a Korean company that makes electronic games. IMPAC, like Motley Fool Income Investor pick Annaly Mortgage (NYSE:NLY), boasts a better-than-10% yield on its stock, which is funded through rapidly rising net income. Webzen, on the other hand, trades for less than five times its net cash, and generated more than $20 million in free cash flow last year. A stroll to the punch bowl to learn more about these two might be worth your while.

When they all look like swans...
The process of finding swans can be like kissing frogs -- do it enough times and maybe you'll run across a prince. Then again, if finding winners were easy, Malkiel's book would be in the bargain bin instead of on the bestseller list. But that doesn't mean you have to settle for sub-par stocks and sub-par returns. You can dance with every ugly duckling in the room, guaranteeing yourself a soiree with at least a couple of swans.

How do you that? There are two ways, really. You could buy a mutual fund that focuses on unloved small caps, but doing so is an, um, commitment, usually of 12 to 18 months. If you want nothing more than a few dates and a good time, but also the possibility of a committed relationship if you find the swan of your dreams, then an Exchange-Traded Fund, or ETF, might be better. ETFs trade like stocks, but offer the diversity of mutual funds. They're usually pretty cheap, too. (You can find out more at the Fool's nifty new ETF Center.)

ETFs aimed at small caps come in all sorts of flavors, from the iShares Morningstar Small Growth Index (NYSE:JKK) fund, which tracks Morningstar's index of fast-growing small caps, to the streetTRACKS Dow Jones U.S. Small Cap Value (AMEX:DSV), which follows the Dow Jones index that tracks 370 deeply discounted stocks.

A Foolish two-step
Though you'll often hear that the profits are in following the smart money, it's exactly this lemming-like approach -- where everyone is trading on the same information -- which Malkiel warned could destroy returns. I have no doubt he's right on that score. But the efficient market theory simply doesn't apply to stocks that Wall Street and the media ignore. So the next time you're all dressed up with nowhere to invest, try one of Wall Street's ugly ducklings. You might just find one of the stock market's lucrative swans.

Tom Gardner and our Foolish band of analysts hunt for the swans of the stock market daily. Join them. A free, 30-day trial to Motley Fool Hidden Gems is yours for the asking.

But you don't need a subscription to learn more about those sexy, lovable ETFs. Everything you need is joyfully free at our ETF Center.

Fool contributor Tim Beyers thankfully hasn't been a wallflower since high school. He has no position in any of the companies mentioned in this story. To get a peek at his weird hobbies and his stock holdings check out Tim's Fool profile, which is here. The Motley Fool is investors writing for investors.