Question: Where are the biggest stock mispricings?

The general answer is that they lie in the dark corners of the market. The places with incomplete, unreliable, or conflicting information. The places where even Wall Street analysts rarely tread.

The specific answer is smaller-cap stocks and foreign stocks.

Now imagine the mispricings that can come with smaller-cap stocks that also happen to be foreign. Don't think too hard. I've got an example that's going to blow your mind.

How these mispricings occur
Before I reveal my example, you need to understand exactly why foreign small-caps can be wildly mispriced. One of the best ways to shine light on a dark subject is to study its opposite, and the opposite of a foreign small cap is an American large-cap stock.

When we talk about the prospects of an American large cap, we take a lot of things for granted, including:

  • Firsthand knowledge.
  • Safety in watchdog numbers.
  • System stability.
  • Track record.

Let me briefly explain.

Firsthand knowledge
Even folks who aren't tech-savvy can verify some of the claims AMD (NYSE: AMD) and Intel (Nasdaq: INTC) make. Per their income statements, Intel has more than six times the sales of AMD; as a very rudimentary sniff test, we can walk into a Best Buy and physically see the computers with "Intel Inside" stickers and compare them to the number of AMD-based computers.

Another income statement example: Intel's R&D budget is the same size as AMD's total sales, traditionally giving Intel a rare moat in the technology space. But with technology, advances aren't always correlated with R&D spend. AMD bulls are banking on AMD doing more with less. As investors trying to compare the prospects of their technologies, there is a wealth of credible information out there on numerous tech sites. That's not true for many foreign large caps, much less foreign small caps.

Safety in watchdog numbers
In the U.S. markets, we have the Securities and Exchange Commission and major stock exchanges like the NYSE and Nasdaq setting stringent reporting requirements and keeping watch.

Meanwhile, we get ample (if short-term-focused) analysis from Wall Street analysts. A famous stock like Disney (NYSE: DIS) has 31 Wall Street analysts following it. A less famous but just as big company like oilfield services provider Schlumberger (NYSE: SLB) has 32, while a smaller but popular stock like Netflix (Nasdaq: NFLX) has 33.

With safeguards like watchdog agencies and focused analysts in place, we have some assurance that past earnings are trustworthy. When we look at trailing earnings multiples (price-to-earnings ratios of 18, 28, 46 for Disney, Schlumberger, and Netflix, respectively), we can focus on whether those valuations are expensive rather than whether they're fraudulent.

We can combine the trailing and forward earnings multiples estimates (15, 17, 30 for Disney, Schlumberger, and Netflix, respectively) with key drivers (e.g., the Marvel acquisition for Disney, the growth of the oil and gas industry for Schlumberger, and the rise of video on demand for Netflix) to generate reasonable going-in positions on the companies.

For example, given the multiples, I'd be looking to make sure Disney and Schlumberger could defend and moderately grow their earnings. I'd also be looking to see if Netflix could not only defend itself against the decline of DVDs but also substantially grow its earnings.

Even with all these watchdogs in place, though, due diligence on these going-in positions is required. Fudged financials and outright fraud slip through the cracks ... but imagine how bad it could get when no one's watching.

System stability
The U.S. is about as good as it gets in terms of providing a safe environment for capitalism to operate. Management doesn't have to spend too much time fretting about the threat of civil unrest, a government arbitrarily enforcing property rights, or the illegal activities of competitors.

That's not necessarily the case for a foreign company, large or small.

Track record
No matter what you think of the investing thesis behind Disney, Schlumberger, and Netflix, these large U.S. stocks have verifiable track records. Disney, for example, was founded in the 1920s and went public in the 1960s.

Many foreign small caps have problems with both the "verifiable" and the "track record" parts of that request.

So why invest in a foreign small cap?
At this point you may be forgetting why anyone would invest in a small foreign company. Let me remind you. For those investors with a competitive advantage, there are serious opportunities to rake in outsized returns due to stock mispricings.

Let me give you an example.

The company is called China Marine Food Group (AMEX: CMFO). It sells salty seafood snacks like dried squid and barbecued sleeve fish.

To the average sane American investor, this sounds (1) gross and (2) not worth further research. But Motley Fool Global Gains co-advisor Tim Hanson would disagree on both counts. These snacks won't play in Peoria, but Tim notes that "they're basically the Chinese equivalent of potato chips." And boy is he glad he investigated further.

He found a company trading for a P/E ratio under 5, but after backing out the cash, the multiple was just 1.7 times earnings -- for a stock expecting more than 20% top-line growth.

If you've been following along, you can probably guess why it was so cheap: It's a very small Chinese company that makes questionable-sounding snacks. It operates in a country known for its government interference, not its corporate governance. Kraft this ain't, folks.  

So is China Marine Food Group a buy?
As part of his duties as Global Gains co-advisor, Tim supplements the knowledge he gains at investor conferences with trips around the world. On his trips to China, for example, he meets with companies' management and tours their facilities. These meetings not only allow him to vet specific stock picks, but also allow him to compare and contrast companies, industries, and countries.

This on-the-ground experience is why he judged the risk to be worth the potential reward on China Marine Food Group when he recommended it back in May 2009. It's gone up over 140% since then, so it no longer trades at that 1.7-times earnings figure -- but Tim still rates the company a "Best Buy."

For a Chinese pick that hasn't run up, check out Guangshen Railway (NYSE: GSH). It's currently trading for less than its tangible book value. That's exceedingly cheap for a capital-intensive business. You can see Tim's full analysis on Guangshen as well as his insights from his most recent scouting trip to Greece with a free, 30-day Global Gains guest membership. Just click here to get started.

Anand Chokkavelu owns shares of Disney. China Marine Food Group and Guangshen Railway are Motley Fool Global Gains picks. Walt Disney, Best Buy, and Intel are Inside Value choices. Walt Disney, Best Buy, and Netflix are Stock Advisor recommendations. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended a buy calls position on Intel and a bull call spread on Best Buy. The Fool owns shares of Best Buy and has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.