Big Winners for Small Investors

Some years ago, an eccentric Midwestern billionaire boasted that he could earn 50% a year on a portfolio of ordinary common stocks. There's a roughly 100% chance you know his name. Of course, there was a catch.

Or maybe that never really happened at all. Whenever I bring it up, I get bombarded with emails saying it can't possibly be true. So let's put it to rest: Did this celebrity investor really make that 50% boast? And if so, what was the one condition?

Enter a flock of Jayhawks
While we debated who said what and when, a bunch of students actually did something about it. They trudged across Kansas and sat down with the guy.

And they simply asked him, "Did you really make that infamous '50%-per-year' guarantee? And more importantly, would you stand by it today?"

You'll be surprised how he would do it
To earn you 50% per year -- essentially doubling your money every 20.5 months -- this fellow wouldn't buy the stocks that made him a legend, like publishing giant Washington Post (NYSE:WPO). He wouldn't even buy his own $155 billion company.

So what would he invest your money in? Obscure outfits with names you've never even heard of, most likely. How do I know? He told us. Remember the catch?

This guy would guarantee he could earn you 50% per year ... only if he had less than $1 million to invest. That's because he would be loading up on undiscovered, thinly traded, small companies -- the one area in the market where the pros can't go, and where individual investors like us have an advantage.

Why Warren Buffett wishes he were you
You knew 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 backward. After all, the big money on Wall Street has all the advantages.

Right? Wrong.

For one thing, most pros have way more than $1 million to invest, so they can't mess around with great, up-and-coming small companies -- at least, not without risking running up the price or buying a controlling stake in the company.

That's why you see so much trading volume in the usual suspects. Take a look at these examples I pulled from the most widely owned, heavily searched, and massively traded NYSE stocks.

And over on the Nasdaq? How about Research In Motion (NASDAQ:RIMM), weighing in at $38 billion and trading 16 million shares a day? On Wall Street, they call this "liquidity." That's really a polite way of saying "the usual suspects buying and selling the same old stocks to each other."

In other words, 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; those usual suspects don't have many doubles left in the tank -- much less one every 20 months or so.

But 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 today, give or take. 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 critical. In fact, combining small-cap potential with old-school value may be the missing link between big profit potential and Buffett's 50%-per-year promise.

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

Yes, there are bargains out there
Despite last year's pullback and the recent bounce, I still believe this is a great opportunity for small-cap investors like us. Late last year, Marty Whitman, one of my favorite money managers, called this the buying opportunity of a lifetime. Warren Buffett loaded up on U.S. stocks last fall, too.

Same for the team my old friend Tom Gardner assembled to carry on his Hidden Gems work. Right now, Tom's team of analysts is putting its money where its mouth is -- to the tune of $250,000 in real money. So far, so good. Thirteen of the portfolio's 14 holdings are in positive territory, including positions that are already up 54%, 75%, and even 121%. If you're not making money like that, you could be.

But don't take my word for it. See for yourself. Take a look at Hidden Gems for free. If you're not convinced at any point during the first 30 days that the service can make you money, I'll personally make sure you don't pay a cent. To learn more about this special free trial offer and to take a peek at the real-money portfolio, click here.

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

Paul Elliott owns shares of Bank of America. You can view the entire Motley Fool Hidden Gems scorecard instantly with your free trial. The Fool has a disclosure policy.