The Home Run Stock You’re Too Afraid to Buy

Do you remember when you tried your first beer because everyone else was doing it? Are you the type who sees all the big movies on opening weekend so you can talk about them at work on Monday morning?

Humans are social animals, but that impulse to be part of the crowd is destroying your chance to find the next home run stock.

"Don't look dumb"
Michael Lewis, the author of Liar's Poker, is one of the great raconteurs of business tales. While he's dismantled Wall Street in his firsthand account of life as a trader, he's also probed the cozy world of baseball in the more recent Moneyball. In this latter book, he explores why the Oakland A's -- one of the lowest-budget teams in all of baseball -- suddenly became one of the winningest around the turn of the 21st century.

The team didn't do what everyone else was doing. It defied conventional wisdom with a unique process:

  1. By working with experts, the team's otherwise-emotional general manager, Billy Beane, implemented a new, scientifically based means to evaluate talent.
  2. The general manager had to implement his system even though all of his talent scouts -- and most of the entire league -- thought the method was useless.
  3. After he'd snapped up his new talent at low prices because no one thought the players were good, Oakland suddenly began to dominate the league, even though it had one of the lowest payrolls in baseball.

The secret?
Sure, the system was good. But the scientific basis had been around for a couple of decades. In fact, the developers of the system had to practically beg baseball teams to use it. Until Beane came along, teams continued to do what they had always done, because it was safe. No one would criticize you if you bought what everyone else was buying.

The real secret, Lewis confides, is that Beane had the courage to look dumb if his system didn't work. It's much easier to do what the crowd does and fail than it is to do something different and succeed.

And what held major league teams back for decades is what's holding many investors back from the next great stock. They're afraid to look dumb. That's it.

During the boom, that kind of psychology led to purchases of popular, "can't lose" stocks such as SunTrust (NYSE: STI  ) and JPMorgan Chase (NYSE: JPM  ) , both of which were teetering on the brink of the housing collapse. It also led to the rush out of these same stocks just when they were heartbreakingly cheap early last year, at prices that more than discounted future problems. 

Now those stocks have nearly tripled off their lows, and yet with a massive housing overhang, it's unclear exactly how the banks will fare going forward, even though the Fed has promised an extended period of near 0% rates. You looked dumb if you were purchasing the stocks just when they were the cheapest, but now the easy gains are off the table, and optimistic results are priced in.

All greatness comes from the contrarian
Oakland's contrarian streak is what led it to success. That's exactly the approach that the experts at Motley Fool Hidden Gems use when evaluating a small-cap investment. And it's what Hidden Gems co-advisor Seth Jayson told CNBC when he discussed investments with the talking heads: He's not afraid to pick the great stocks that no one's heard of.

Superior investments are found where no one else is looking. That means that you and your friends have probably never heard of the big winner of the next decade. Who had really heard of Hansen Natural 10 years ago? It was a $44 million company then. Since that time, this purveyor of Monster energy drinks has become a nearly $4 billion behemoth. That's over 50% average compound growth.

Hansen Natural wasn't just some lucky story; it had great execution even back then. In 1999, the company sported attractive metrics such as a 28% return on equity and a 26% return on capital. But who had heard of it? The world was enthralled with dot-coms that subsequently went bust. 

If you didn't own one of the New Economy businesses, you were a (small-f) fool, since they would grow forever. Cash machines such as Cisco were valued at more than 100 times earnings in 1999-2000. Even super-investor Warren Buffett was laughed out of town for refusing to buy what the crowd was snapping up. But years after the dot-com bubble burst, Buffett is as wealthy as ever, while those who followed the fashion are bust.

Here are some lesser-known small caps that today have the same high returns on capital and equity that Hansen had before its big run:

Company

Market Cap

P/E Ratio

Return on Capital

Return on Equity

j2 Global Communications (Nasdaq: JCOM  )

$1.0 billion

15.8

20.9%

21.0%

American Public Education (Nasdaq: APEI  )

$776 million

29.7

36.7%

34.9%

Landauer (NYSE: LDR  )

$567 million

22.5

28.5%

33.8%

 

Quality Systems (Nasdaq: QSII  )

$1.7 billion

36.2

28.6%

28.8%

Data from Capital IQ (a division of Standard & Poor's).

Given such strong performances, these small caps are definitely worth following up with further research. They have managed to grow sales at an impressive clip over the last few years, despite the economic climate. J2 Global has pushed sales higher at an annual average 16% higher over the last five years. Quality Systems has done even better, at 28%, while American Public Education has seen sales grow at a 53% compound rate over its three or so years of existence.

Small is beautiful
The expert analysts at Motley Fool Hidden Gems look exclusively for the market's overlooked small-cap stocks. That's where you're going to find the next great home run stock -- if you're like Billy Beane and Warren Buffett and not afraid to go against the crowd.

If you'd like our experts 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.

Already a Hidden Gems subscriber? Log in here.

This article was originally published Sept. 3, 2009. It has been updated.

Jim Royal, Ph.D. owns shares of Procter & Gamble. Quality Systems is a Stock Advisor choice. The Fool owns shares of American Public Education. The Fool has a disclosure policy.


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