You've all heard the joke: "Where does an 800-lb. gorilla sit? Anywhere it wants!" That's pretty much how many small investors view the gorillas of the investing world: the mutual funds, pension funds, and investment banking houses. Nigh on omnipotent, these mega-investors have the power to move markets not just with their multimillion-dollar trades but even with their musings that ABC, Inc. is "overvalued" or their decisions to "downgrade" XYZ Corp.
Case in point: Last Thursday, banker Bear Stearns downgraded computer maker Apple (NASDAQ:AAPL) to "peer perform" based on Apple's stock price having passed Bear Stearns' price target. No other news broke on Apple that day -- an up day for the market in general -- yet the company's stock price fell, based solely on Bear Stearns' announced sentiment. Within a few hours, Apple had lost more than $250 million in market value.
Now that's power. The power to destroy or create wealth with a few words. The power to move markets. Small investors may wonder whether it is even possible to compete against such power -- or whether it is best to just throw in the towel and follow the big boys blindly. To buy whatever Citigroup (NYSE:C) tells them to. To mimic the buys and sells of T. Rowe Price. Or to go all in, buy a mutual fund, and leave the individual buy and sell decisions to a professional.
For investors who are tired of playing David to the institutions' Goliath, The Motley Fool offers an excellent resource in the form of our Champion Funds newsletter, which can help investors pick the best fund managers out of a field of also-rans.
But some Fools enjoy the contest -- the striving to outwit, outmaneuver, and outperform the powers that be. These investors have a more competitive bent, and the patience and intestinal fortitude to weather the ups and downs of the small-cap market. For these Fools, we suggest that our market-thrashing Hidden Gems service can be the slingshot you use to fell Wall Street's Goliaths. The following is just one of many ways we use small-cap stocks to rack up big gains.
Mouse-hole investing
Remember the old Tom & Jerry cartoons? On any given day, Jerry (the mouse) would be up to some lovable hijinks when all of a sudden Tom would appear and give chase to Jerry. Jerry could usually outwit ol' Tom by diving through a mouse hole; when Tom tried to follow, he'd find himself unable to fit through.
Small-cap stocks are a lot like Jerry's mouse hole: Small investors can enter and exit them at will -- larger investors may find them impassable. As an individual investor, you have the discretion to invest in, really, most anything you like. And you can allocate your portfolio among as many, or as few, investments as you wish. Got a hunch that the telecom sector is reviving, and want to put all your money in small-cap equipment maker Ciena (NASDAQ:CIEN)? Go for it. Want to diversify but only buy into such mega-cap companies as Coca-Cola (NYSE:KO), Cisco (NASDAQ:CSCO), and Wal-Mart (NYSE:WMT)? More power to you.
But life isn't that simple for fund managers. They face limits written into their corporate charters, their prospectus guidelines, and government regulations that prevent them from buying stock in companies below a certain size or stocks below a certain minimum share price. They also can't invest too much of their assets in any one company or own too large an interest in any one company. In his classic primer for the individual investor, One Up on Wall Street, Peter Lynch describes these and other limitations on the investment choices available to fund managers.
Boiled down, Lynch's conclusion is this: The larger the institution, the more it is confined to investing in only large-cap companies. A fund manager with $10 billion in assets and 100 "slots" to fill generally doesn't have the option of investing in any company with a market cap of less than $1 billion. And even if he finds a $1 billion company at an attractive price, the stock's liquidity may prevent him from buying in. With each buy order, he pushes the company's price higher.
In order to have any chance of getting into an investment at a decent price, the stock must in fact have a market cap much larger than $1 billion. As a result, institutions tend to shy away from some of the most attractive bargains on the market, leaving the field wide open to individual investors.
Hit 'em where they ain't
It may not be playing fair, but when Hidden Gems investors see a situation like this, we aim to take full advantage. While the average (i.e., the "mean") stock on the S&P 500 -- where big fund managers do most of their stock shopping -- has a market capitalization of much more than $20 billion, the average company recommended in Hidden Gems has a market cap of less than $500 million. What's more, the small caps chosen by Hidden Gems have proven themselves better investments than the S&P large caps -- the General Motors and AT&Ts (NYSE:T) of the world. Over the past year, Hidden Gems recommendations have appreciated an average of 22% in value, while the S&P 500 has risen just more than 2.3%.
There's little doubt that, given their druthers, the big institutions would much prefer to own small companies that wallop the S&P rather than large companies that match or lose to the S&P's performance. Yet if you look at the institutional ownership of GM, for example, you'll see that it's 25% higher than the average institutional ownership of Hidden Gems-size companies. Moreover, the institutions that have to invest in GM are the gorillas of Wall Street: State Street, Goldman Sachs, and the like. The owners of small-cap companies, on the other hand, have unfamiliar names: Second Curve Capital, Staro Asset Management. They're hedge funds -- institutions that love profits just as much as the big boys, but that operate under fewer restrictions on their investment decision-making.
Play to your strengths
So, you see, there are really two kinds of institutions in the investing world. There are those -- the gorillas -- that are bound by rules, regulations, and the like, to invest in "safe" large caps. And there are those -- the hedge funds -- that are freer to seek profits wherever they may lie. The big institutions buy large caps not because they necessarily want to, but because they have to. And their investment returns suffer because of it. The hedge funds, on the other hand, buy whatever company offers the most compelling case for capital appreciation.
As an individual investor, you are much more like the latter than the former in your freedom to invest as you like. The Foolish thing to do in a situation like this? Play to your strengths. Simply put: Invest in the small-cap opportunities that Wall Street's gorillas would invest in, if they could.
If you really want to keep company with gorillas, take your kids to the zoo this weekend. That's a whole lot more enjoyable than receiving underperforming returns from the large-cap, slow-growth companies touted by Wall Street's giant funds. When you get home, sign up for a free trial subscription to our Hidden Gems newsletter. Every month, we'll give you two recommendations of top-banana small caps that would set the gorillas of Wall Street to drooling.
Fool contributor Rich Smith owns no shares in any companies mentioned in this article. The Motley Fool is investors writing for investors.
