Home Run Stocks Wall Street Shuns

Do you remember doing something dumb just because your friends were doing it? (Short answer: we've all been teenagers.)

Did you buy financial stocks such as Bank of America (NYSE: BAC) and Citigroup (NYSE: C) in 2006 and 2007 when the housing market was rockin', profit was growing quickly, and these two giants paid ever-growing dividends?

But that desire to be part of the crowd can prevent you from finding the next home run stock and making the greatest trade ever.

It takes iron guts
In The Big Short, a thematic follow-up to his acclaimed Liar's Poker, Michael Lewis again dismantles the culture of Wall Street, especially the herd mentality that pervades even some of the otherwise sharpest companies.

He highlights Dr. Michael Burry, head of Scion Capital, a hedge fund based in California. Burry won big by betting against subprime mortgages using credit default swaps -- a year before fund manager John Paulson got in on the game. From its inception in late 2000 until June 2008, Scion Capital gained 726%, compared to the S&P's increase of just 2%.

How did he do it?
To make such massive gains, Burry had to defy the consensus of Wall Street, which was that housing prices were only going to go up … and up and up. That took a massive dose of psychological fortitude.

1. Burry isolated himself in his California office so that he was able to analyze the market and think independently.
2. In late 2004 and early 2005, he closely examined the mortgage-backed securities that were being sold willy-nilly across the world, an analysis that most of the Street didn't attempt until a couple years later. He discovered that lenders such as Bank of America and Citigroup were making awful loans to underqualified borrowers.
3. After his extensive research, Burry wagered on subprime's meltdown, and then held on to his positions while virtually everyone -- especially his investors -- questioned his judgment and sanity.

Now, Bank of America, Citigroup, and herd-following investors are waiting for a housing rebound that has been "just around the corner" for the last couple years. But current data suggests that housing prices are set to turn down again, leaving these banks in even worse shape.

Greatness comes from the contrarian
As Burry demonstrated, great investments are found where no one else is looking, so you likely haven't heard of the next decade's 40-bagger.

To find that highflier, you need to delve into the high-growth small caps that Wall Street shuns. Specifically, you want to look for strong profitability and sales growth, regardless of whether the company is a household name yet. Over time, update your analysis and hold on to the stock if it's growing (or better, accelerating) its profitability. Surprisingly, many highfliers are hiding in plain sight.

Outside of the oil patch, who had heard of XTO Energy, which was a $300 million company, in 1999? Dotcom fever was sweeping the world.

But since then the stock has managed to grow over 41% per year, into a $24 billion natural-gas giant. In fact, the company has become such a player in the natural gas arena that ExxonMobil (NYSE: XOM) recently acquired it. With natural-gas prices at record lows, you could argue that ExxonMobil is playing the contrarian and getting in while clean-burning, plentiful, and cheap gas is being discussed as the energy source of the future, before a growing global economy pushes gas prices back into the stratosphere.

The kind of growth XTO demonstrated is impossible to find with today's large caps such as Apple and Microsoft, precisely because everyone "knows" they are good investments. Instead, you have to look to small caps, which can have great performance and still not be noticed by Wall Street.

Even in 1999, XTO was clearly a great company. For the full year it sported a return on equity of 19.5% and bursting-at-the-seams revenue growth of 35%. But in 1999, energy wasn't the "hot sector.

Below are a few small caps that have some of the same high metrics that XTO had in 1999.

Source: Capital IQ, as of May 24, 2010, TTM = trailing 12 months.

Whereas high sales growth indicates that the company's products are in great demand, a strong return on equity indicates that the company is earning a good return on the money that shareholders entrust to it.

Now, one year of excellent results doesn't mean these companies will become the size of XTO, but the results do give a good indication of where to look to find your ten-baggers. Look for highly profitable small caps that tend to be ignored by the Street.
Small is still beautiful
This contrarian approach is used by the advisors at Motley Fool Hidden Gems in their search for small-cap stocks. Co-advisor Seth Jayson told CNBC that he refuses "to play the hot sector game" but instead buys the sector before it becomes popular.

If you'd like our experts Seth Jayson and Andy Cross to help you find superior small-cap ideas, you can check out all of our Hidden Gems stock research, as well as our eight "Buy First" small caps for new money now, free for the next 30 days. Click here for more information.

Jim Royal, Ph.D. owns shares in Bank of America and Microsoft. Microsoft is an Inside Value recommendation. Apple is a Stock Advisor pick. China Green Agriculture is a Global Gains pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of XTO Energy and China Green Agriculture. The Fool has a disclosure policy.