The Best Investment Wall Street Won't Touch

As an investor, you have a lot of information at your fingertips. In fact, you're probably flooded with data touting the decade's best stock or next year's most influential company.

Whether you're a serious investor or just a beginner, it can be tough to filter out the noise to find the stocks that will truly enhance your financial well-being.

So what should you pay attention to? And what should you ignore?

Stay away from Wall Street
Ignore the analysts. In fact, you can pretty much ignore everyone on Wall Street, for that matter.

Why? They're not very good at serving you.

The Proprietary Research team at Thomson Reuters surveyed analyst recommendations across the S&P 500 index of stocks, and came up with some shocking results. Out of the 9,162 recommendations covering these stocks, 93% were bullish. Strange -- I didn't realize the market was so rosy.

At the start of 2008 -- one of the worst years in our market's history -- analysts had a "buy" or "strong buy" rating for nearly 50% of covered equities. Reputable researchers were telling investors to buy companies like Chesapeake Energy (NYSE: CHK  ) just before the commodity bust, and Bank of America (NYSE: BAC  ) in the middle of the biggest financial crisis in the last 70 years.

Needless to say, neither of these companies has returned to the share prices they were at when Wall Street suggested them. As The Wall Street Journal so tenderly stated: "Wall Street analysts remain a cheerleading chorus whose published advice is a dubious guide for serious investors."

Why are they so wrong?
Despite those buy and sell ratings, analysts aren't really working for us. They're part of a complicated web of alliances that serve companies and institutions before they serve individuals.

For example, they have relationships with the companies they rate -- and slapping a "sell" rating on one of those companies can often imperil that relationship. In addition, their analysis is primarily serving the company they work for, which has a vested interest in advancing certain stocks for institutional investors.

But here's a little secret: It's a good thing analysts aren't working for you.

The best strategy
The more people following a stock, the less chance you have of finding information that hasn't already been uncovered. And it's the discovery of new information that often changes the price of a stock, as people react to news, to forecasts, or to new data. That's why it's hard to find substantial price discrepancies with huge companies like Home Depot (NYSE: HD  ) or Intel (Nasdaq: INTC  ) -- each company has more than 25 analysts covering it!

You also don't want to waste your time looking at stocks that are simply the latest fashion. For example, stocks like SunTech Power (NYSE: STP  ) or Petrobras (NYSE: PBR  ) are in the ultra-trendy solar and international sectors, and those are probably areas you want to avoid.

However, small-cap stocks are rarely followed by analysts or individual investors, which gives you the ultimate competitive advantage when it comes to unearthing new information. In addition, because they're small, they have room to run, so if you can find a fast-growing company, it may have the chance to be the next home run stock.

But not all small caps are good investments.

You don't want to chase returns -- that's a recipe for disaster. For instance, you should probably avoid stocks like Dollar Thrifty Automotive and China North East Petroleum -- they've already seen 3,000% plus gains in the past year on little real news, so it's unlikely they'll enjoy that type of success again.

What you should look for in a small cap? Membership in a relatively unpopular industry (that way you can ensure not many people are evaluating it), a strong position in its market, a demonstrated ability to increase sales, and a reasonable sale price.

A great place to start
Here's an example of three cheap stocks that have grown their revenues by at least 10% annually over the last three years, have a return on equity north of 12%, and fit all of our "small cap" criteria:

Stock

Market Capitalization

Analyst Coverage

Price-to-Earnings

3-Year Revenue CAGR*

GigaMedia

$169 million

2

5.0

52%

AZZ Inc.

$423 million

4

10.7

17%

Innophos Holdings (Nasdaq: IPHS  )

$588 million

4

8.5

7%

*CAGR = compound annual growth rate.

Not only are these stocks excellent performers, but they're trading on the cheap -- and best of all, they're so small that Wall Street won't bother to touch them. Each company has a strong foothold in its industry and has consistently illustrated growth, so there's every reason to believe they'll keep performing well into the future.

Take Innophos Holdings, for example. This small company produces specialty phosphates that are used in everything from beverages to laundry detergent to fertilizer. Innophos controls about 40% of the North American market, and since customers have little incentive to stray, the company holds significant pricing power.

It's not the most exciting story -- but that's the point. The less exciting the story, the better the opportunity, because fewer investors will have the wherewithal to do any due diligence.

These are the types of stocks that the Motley Fool Hidden Gems team looks at and recommends each month. If you're interested in learning more about which small-cap stocks they think have the best chance at crushing the market, take a free, 30-day trial. Just click here for more information. There's no obligation to subscribe.

Already a subscriber? Log in at the top of this page.

Fool contributor Jordan DiPietro doesn't own any shares mentioned above. Chesapeake Energy, Home Depot, and Intel are Motley Fool Inside Value choices. Suntech Power is a Rule Breakers recommendation. Petrobras is an Income Investor selection. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of AZZ incorporated, Chesapeake Energy, and Innophos Holdings. The Fool's disclosure policy is written in small caps.


Read/Post Comments (6) | Recommend This Article (46)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2010, at 5:33 PM, footchester wrote:

    GigaMedia ?!? the same Gigamedia that was a two or three time 'official recommednation' for Global Gains subscribers, only to become a "sell" recommendation at a substantial loss. A company that went 18 months without releasing ANY results? That GigaMedia???

  • Report this Comment On March 20, 2010, at 2:32 AM, ET69 wrote:

    Hey the Innophos recommendation has worked out well for me. Thanks Fool!

  • Report this Comment On March 26, 2010, at 8:10 PM, TMFPhillyDot wrote:

    @footchester,

    When GIGM was recommended it was trading above $9 per share, it's now down at about $3.18. And, if you are familiar with the Fool, one thing you will know is that we all have different opinions and that we champion diversity of thought, so it's not uncommon for Fools to have varying ideas on the same stocks.

    Thanks though for the comment.

    Foolishly,

    Jordan (TMFPhillyDot)

  • Report this Comment On March 28, 2010, at 5:21 AM, PeeyushFool wrote:

    You have given a statistic that on Wall street out of the 9,162 93% were bullish. Can you please give similar statistics for fool caps ? I think the number for 4* & 5 * would be similar

  • Report this Comment On March 28, 2010, at 5:29 AM, PeeyushFool wrote:

    Sorry I got the number its 1979 out of 5610 (Caps is really user friendly), so with fool caps we have 35% stocks that are bullish. Much better ! But our tendency like anybody's is to rate only the stocks that we like and generally do not rate stocks that we dislike.

  • Report this Comment On April 11, 2010, at 10:18 AM, paperhunter wrote:

    Do you really feel that China North East Petroleum has nowhere to go?

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