Make a Fortune With These Untouchable Stocks

Where can the hidden value in Apple be? Some 22 million shares trade hands each day. At least 42 Wall Street analysts -- not to mention every punter from here to Timbuktu and your Aunt Ethel -- interpret the meaning of CEO Steve Jobs' every pause and sigh. And the experts, professional and amateur alike, have combed every SEC filing and patent application to glean the slightest prediction of Apple's next product. The iTV? The iGrill? What was that rumor about David Hasselhoff coming out of Apple's Cupertino HQ?

One of the secrets of investing is to look where no one else is looking. Sure, handicapping Apple's next product is fun and all, but it's not likely to give you an advantage over the market. And that's exactly what you need if you want to generate outsize returns.

Buy the untouchables
Finance researchers Eugene Fama and Kenneth French discovered that one in eight small-cap growth stocks becomes large every year. According to these researchers, such soon-to-be big companies return on average up to 62% annually, The Wall Street Journal notes.

With such achingly good returns, why would Wall Street shun these small caps?

In large measure, it has to do with Wall Street's deep pockets. The investment houses have to focus on the biggest and most liquid names, like Altria, Apple, Bank of America, and Citigroup. They focus on stocks that trade up to hundreds of millions of shares a day so that they can shuffle in and out of positions rapidly. Compare that to small caps, many of which trade fewer than 50,000 shares, and have market caps in the millions instead of billions. Because the Street is unable to take positions in many small caps, it also doesn't provide much research coverage.

Their tiny size and low volume mean that small caps are untouchable for most of Wall Street. Still, some mutual funds do fish for big-time winners in the small-cap pond. But just when those stocks are poised for breakout gains, the funds usually have to sell because owning larger stocks violates their charters.

For example, in 1983 T. Rowe Price's New Horizons fund sold a position in Wal-Mart that would now equal $14 billion, or twice the value of its whole portfolio, if it had only held on. Ironically, the retailing giant's sales growth slows just as Wall Street becomes more interested in the company, as you can see in the table below. And Wal-Mart sales will only slow further as it expands its reach.

The New Horizons fund had a similar experience with Starbucks and had to forfeit a potential $200 million gain. The sales growth of companies that have risen to become today's household names has slowed remarkably. And their stock returns (though in Starbucks' case nothing to sneeze at) have slowed considerably from their heady growth days.

*Starbucks growth from 1991-2000.

Tomorrow's Apple
But, for the same reason that it's so much fun to speculate on what marketing trick Apple is going to perform next, it's also psychologically difficult to buy small caps that you've never heard of. Humans are social -- we like to do what others are doing and we like to talk about it.

But that impulse can really kill your returns and prevent you from finding the next home run stock. It's too easy to buy the stocks that your friends or colleagues are buying. It's much easier to do what the crowd does and fail than it is to do something different, such as buy small caps, and succeed.

Here's the opportunity
For all these reasons, you have to find the market's hidden gems if you want outsize returns. And that's what the world's greatest investor, Warren Buffett, has said as well, claiming he could get 50% annual returns if only he had less than $1 million.

To find such small caps, look for the following qualities:

• Generous free cash flows.
• Heavy on assets, light on debt.
• Dominant position in a profitable niche.
• Intelligent, driven, yet not-too-flashy management teams.
• Executives with significant personal stakes in the business.

Strong free cash flow shows that the business can bring high levels of actual cash into the business, not just book earnings and never quite collect them. A debt-light position means that a small-cap has the financial flexibility to navigate tough economic times. By being a large operator in a niche market, small companies can generate outsize profits without attracting competition from large-caps. Managers with "skin in the game" helps align their interests with ours, and their passion and drive for excellence mean they're looking to maximize their wealth (and ours!)

Those are the criteria that the Motley Fool Hidden Gems team focuses on when selecting small caps for its real-money portfolio. Below are a few companies that meet those requirements, one of which is a Hidden Gems choice.

Source: Capital IQ, as of March 30, 2010.

Because they're so profitable, companies like those listed above are ripe for gains, or perhaps even buyouts. In fact, in the past nine months, the Hidden Gems team has recommended four companies that have been acquired, or shortly will be, at nice premiums.

If that sounds attractive to you, you can check out all of our Hidden Gems stock research, as well as our "Buy First" small caps for new money now, free for the next 30 days. The expert analysts at Hidden Gems look exclusively for the market's overlooked small-cap stocks. Click here for more information.

Already a Hidden Gems member? Log in here.

This article was originally published on April 22, 2010. It has been updated.

Jim Royal, Ph.D. owns shares in Bank of America. Lowe's and Wal-Mart are Inside Valuerecommendations. Perfect World and Vistaprint are Rule Breakers picks. Apple and Starbucks are Stock Advisor recommendations. The Fool owns shares of and has written puts on AmTrust Financial Services. The Fool owns shares of Perfect World. The Fool has a disclosure policy.