"The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent." -- Seth Klarman, founder of the Baupost Investing Group
I learned early on that I come from contrarian stock. At 10 years old, I asked my dad why he didn't buy a nice new car like the other dads in the neighborhood -- after all, he worked hard days and weekends and could have afforded it. He looked at me and said, "Son, cars are depreciating assets."
Despite examples to the contrary, however, we as humans are hardwired not only to care what other people think, but to follow the herd in almost every scenario.
Especially your neighbors
Consider the following experiment conducted by Robert Cialdini, professor of both psychology and marketing.
He wanted to find out what would persuade people to conserve energy, so he put leaflets in people's doorways with different messages. One control group received no leaflets; one group received leaflets with facts about how energy conservation helps the environment; another group received information on how much money they could save; and one group received leaflets that said, "The majority of your neighbors are conserving energy." Later, they checked the gas meters to see who had, in fact, changed their energy consumption.
I'm sure you see where I'm going with this -- the most effective leaflet was the one telling people that their neighbors were conserving energy. As Cialdini says, people will almost always do things they know or believe other people are doing them. Think about how many times you've stopped and looked up at the sky just because other people were doing it.
That's why bubbles are so devastating -- we tend to get caught up in the excitement, buying shares of Oracle (Nasdaq: ORCL ) and Adobe (Nasdaq: ADBE ) for more than $40 per share right before they plunged over 80%. We couldn't help it -- everyone else was doing it.
Far from the madding crowd
There are some great reasons to practice going against the grain -- especially when it comes to investing.
Following stocks that everyone else is following hardly gives you much of an advantage -- you're forced to compete against not only thousands of other investors, but hundreds of scrupulous Wall Street analysts.
On the other hand, tracking stocks that are typically ignored -- i.e., small-cap stocks -- allows you to find mispricing situations, and once you can identify a great company that's undervalued -- well, you've just hit a gold mine.
For example, I bet most of your neighbors haven't heard of Atheros Communications (Nasdaq: ATHR ) . This small-cap company plays in the wireless communications segment and provides low-cost, single-chip solutions for various products. Because of its nimbleness and adaptability to the market, Atheros caught the eye (and the recommendation) of our Motley Fool Hidden Gems analysts.
Over the last half decade, it's earned over 20% annualized gains, and in the past year alone, it's experienced a whopping 127% return. It currently has zero debt, and over the last five years it's generated consistent free cash flows and increased revenues by over 20%.
You simply can't find that type of growth from companies your neighbors have already heard of -- blue-chip stocks like General Electric (NYSE: GE ) or Wells Fargo (NYSE: WFC ) . Those companies are just too big to grow that fast again.
Keep it in the family
To find the stock champion of the next 10 years, you'll need to avoid the herd -- and look where your neighbors aren't. That means seeking out small-cap stocks that are being ignored, then finding the ones that have excellent growth, that return money to shareholders, and that are trading cheaply.
For example, here are some lesser-known small caps that have the qualities needed to see some enormous gains:
|
|
Market Cap
|
P/E Ratio
|
5-Year Annualized Revenue Growth (TTM)
|
Return on Equity (TTM)
|
|
The Pantry
|
$335 million
|
4.8
|
21%
|
17.1%
|
|
Sun Health care Group (Nasdaq: SUNH )
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$374 million
|
3.4
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19%
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32.6%
|
|
M&F Worldwide (NYSE: MFW )
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$606 million
|
4.7
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81%
|
29.8%
|
*Data taken from Capital IQ. TTM = trailing 12 months.
I'll be honest -- not all small-cap stocks are going to be a perfect fit. But if you have the guts to pick the less popular stocks, your portfolio will surely reap some tremendous benefits.
Those are the kinds of stocks we buy for our Hidden Gems real-money portfolio -- and our picks are beating the market. If you're interested in seeing the stocks our analysts are recommending, just click here for a free, 30-day trial. There's no obligation to subscribe.
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This article was originally published on October 16, 2009. It has been updated.
Fool contributor Jordan DiPietro owns shares of General Electric. Adobe Systems is a Motley Fool Stock Advisor pick. The Fool owns shares of Atheros Communications and Oracle. Atheros Communications is a Motley Fool Hidden Gems pick. The Fool has a disclosure policy.
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