Buying shares of a promising small-cap stock before Wall Street finds out about it isn't just fun. It's profitable.
That's the conclusion of two University of Florida business professors, Cem Demiroglu and Michael D. Ryngaert, who found that stocks with no analyst coverage enjoyed a near 5% permanent positive return when coverage started. What's more, the best previously uncovered stocks (those that received "buy" recommendations) showed greater long-term returns than their peers.
Given that incredible return potential, it's hard to believe that Wall Street research firms tend to be late to the game here. Yet, according to Cohen Research, nearly 4,500 small caps receive no analyst coverage.
Of course, analysts don't bother with small caps because their customers can't bother with small caps. Wall Street firms sell their research to large institutional clients who tend to have billions of dollars to invest. These institutional clients aren't interested in small caps because their tiny size and limited liquidity make it impossible for the institutions to take positions of any meaningful size.
So if it's not the large institutional investors, who gets these fantastic returns?
If you're smart, that "who" can be you
The best part about the lack of institutional research in the small-cap sector is that it creates pricing inefficiencies. If you look hard enough, you can find small stocks trading for outrageously cheap prices -- particularly after the market's recent volatility.
But there are also pitfalls. A stock that gets no analyst coverage may have limited disclosure and ffer no guidance or earnings estimates, and finding independent opinions on it can be difficult. That means more unknowns, and for many investors, more unknowns mean more risk.
This perception that underfollowed small caps are riskier than the market at large is one of the reasons why the Russell 2000 Index for small caps has dropped substantially over the past six months, more than the broader market. The euphemism for this trend among jittery investors is that this is "a flight to quality."
Don't join the flight ... take advantage
It's clear, however, that quality and size are not synonymous. Witness the recent Bear Stearns debacle, or even Yahoo!'s (Nasdaq: YHOO ) last five unfocused years.
There are 167 large caps -- including Genentech (NYSE: DNA ) , ExxonMobil (NYSE: XOM ) , Cisco Systems (Nasdaq: CSCO ) , Intel (Nasdaq: INTC ) , and Google (Nasdaq: GOOG ) -- that can point to a quality track record of five years of:
- Double-digit earnings growth
- Double-digit operating margins and returns on equity
- Interest coverage ratios of at least 2 to 1.
There are 132 companies capitalized at less than $1 billion -- including Natco (NYSE: NTG ) and Motley Fool Hidden Gems recommendation Drew Industries -- that satisfy the same set of criteria. And these quality small caps are now significantly cheaper than their large-cap peers.
While the quality large caps traded for, on average, nearly 20 times earnings six months ago, they still trade for 18 times earnings even after the recent market downturn.
The quality small caps, on the other hand, have had their average earnings multiple contract -- from 21 times to 15 times -- over the same time frame. That's pretty cheap, and it's happened simply because Wall Street can't be bothered to separate the good from the bad in this sector.
Always buy quality when it's cheap
If you can be bothered to do some small-cap research, now is a great time to pick up shares of top small caps with big-time growth potential before they appear on Wall Street's radar. After all, these stocks are 25% cheaper than they were just six months ago and now check in at better valuations on average than their lower-growth, large-cap counterparts.
We're doing just that at our Motley Fool Hidden Gems small-cap research service, where we're more excited to be small-cap investors today than at any time in our five-year history.
Our picks are ahead of the market by more than 23 percentage points on average, and we know that today's buying opportunities will help us widen that lead. You can read our top picks for new money now -- as well as all of our research and recommendations -- by joining Hidden Gems free for 30 days.
Tim Hanson does not own shares of any company mentioned. Intel is a Motley Fool Inside Value recommendation. The Motley Fool disclosure policy's book club is currently reading Ulrich Haarburste's Novel of Roy Orbison in Clingfilm.