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 ridiculous 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 to 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? As it turns out, he didn't just confirm that 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 $130 billion company.

No, he'd buy obscure companies with names you've probably 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 of the advantages, right? Maybe not.

For one thing, most pros have way more than $1 million to put to work, so they can't mess with a little energy company like Southwestern Energy. Well, maybe they can now -- but not 10 years ago, when the stock started the 2,911% 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 me? Take a look at the names that are consistently among the most heavily traded Nasdaq stocks:

And over on the NYSE? How about Pfizer (NYSE:PFE), trading 68 million shares a day. 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 have 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, give or take. Not bad.

If you'd bought small-cap value stocks instead, you'd have more like $30 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, patience, and 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 Hidden Gems newsletter service. So I know firsthand how rewarding the returns can be when you focus on unloved, obscure, and (most importantly) underpriced small companies.

The Death of Equities?
Fat chance. That wasn’t true when I first heard it in 1979. More likely, this is a rare opportunity for investors like us to make up some lost ground. 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, as they always do.

Of course, I understand why you might not want to go it alone just now. Here's an idea: Do what I do -- lean on the team of advisors at Hidden Gems for ideas and advice. They've never led me wrong. And right now, you can try the entire service free for a whole month.

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Best of all, you're not taking any chances. If you're not impressed at any point during your 30-day trial, I'll personally make sure you don't pay you a dime. Buffett would be proud. To learn more about this free trial offer, click here.

This article was originally published Feb. 10, 2006. It has been updated.

Paul Elliott owns shares of Pfizer. Intel, American Express, and Pfizer are Motley Fool Inside Value picks. You can view the entire scorecard with your free trial. The Fool owns shares of American Express and Intel as well as covered calls on Intel and has a disclosure policy.