Big Winners for Small Investors

There's an old, illuminating story in investing circles, and it goes something like this ...

A cocky Midwest billionaire once boasted he could earn 50% profits year after year, investing in nothing other than ordinary common stocks. Of course, there's a condition.

Or maybe that's all it is -- a story. After all, that's a pretty tall order, and it's been debated for years. So, you're right to wonder: Did this guy really make that claim? And if he did, what was his one condition?

Enter a flock of Jayhawks
While we bickered over who said what and when, a courageous class of business students did something about it. They traveled from their campus in Lawrence, Kan., to Omaha, Neb., and set up a meeting.

Then they asked the guy: Did he ever really make that "50% per year" guarantee? And more important, would he stand by it? He didn't just confirm it -- he went further.

You'll be surprised how he would do it
To earn that 50% per year -- essentially doubling your money every 20.5 months -- this fellow wouldn't buy the blue-chip giants that made him one of the world's richest men ... or even his own $160 billion company.

He'd buy companies with names you've probably never heard. How do I know? He told us. Remember that one condition?

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

Why Warren Buffett wishes he were you
You guessed it was Buffett, didn't you? Well, can you guess why he wishes he were you? Because he has too much money. I know, that sounds crazy. After all, the big money has all the advantages, right? Wrong.

For one thing, big boys like Buffett have way more than $1 million to invest, so they can't mess with small companies, no matter how great their potential -- at least not without risking running up the price or buying a controlling stake in the firm.

That's one reason why you see so much trading volume in the usual suspects. Take a look at these names among the most widely owned and heavily traded NYSE stocks.

And over on the Nasdaq? How about Comcast (NASDAQ:CMCSA) and News Corp. (NASDAQ:NWS), each trading multiple millions a day. On Wall Street, they call this liquidity -- a polite way of saying "the usual suspects buying and selling the same old stocks to each other."

So, if you've got half a billion to put to work this afternoon, you'd better buy something big and forget about the next big thing. But don't expect to be dazzled; even after getting beaten up in 2008, those 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?
Yes and no. 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. Over the course of 80 or so years, it would have grown to about $2 million. Not bad.

If you'd bought small-cap value stocks instead, you'd have more like $30 million. Of course, the word "value" here is key. In fact, combining the potential of small caps with old-school value is the missing link between big profit potential and Warren Buffett's grind-it-out success.

My old friend and Motley Fool co-founder Tom Gardner hammered this into my head when I worked with him on his Motley Fool Hidden Gems newsletter service. I know firsthand how dramatic the returns can be when you focus on unloved, obscure, and (most important) underpriced small companies.

"Be greedy when others are fearful"
That's something else I learned from Buffett. So if you're more comfortable waiting for a pullback after the recent rally, I can respect that. But don't wait too long. I still think this market is a buying opportunity for opportunistic investors. But you're right to pick your spots.

Here's a solution. Sample Motley Fool Hidden Gems for free right now. You can check out the two top picks the analyst team thinks are best positioned to make you money. While you're at it, jot down the stocks they are buying for their real-money portfolio – so you'll have them when you're ready to buy.

But again, I wouldn't sit too long and get caught on the sidelines. I have a hunch the guys at Hidden Gems can help make you money. I guarantee they'll make you a better investor. If you have less than $1 million to invest, that is.

Best of all, there's no risk for you. If you're not absolutely convinced at any point during the first 30 days, I'll make sure you don't pay a dime. This way you'll be ready to move when you decide the time is right. Even Buffett would be proud. To learn more about this free trial offer, click here.

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

Paul Elliott doesn't own any stocks mentioned. Sprint is a Motley Fool Inside Value recommendation. You can view the entire Hidden Gems scorecard and real-money portfolio with your free trial. The Fool has a disclosure policy.