There Are No Cheap Stocks

Legg Mason chief investment strategist Michael Mauboussin talked to us Fools recently about expectations. What his presentation really drilled into me is that there aren't "cheap" or "expensive" stocks. Instead, there are three types of stocks:

1. Stocks that meet the market's expectations.
2. Stocks that fall short of the market's expectations.
3. Stocks that exceed the market's expectations.

Suffice it to say, we'd all like to fill our portfolios with stocks that exceed the expectations the market has priced into them.

This one goes to 11
Thus, it can be much more advantageous to hold Company A, which grows earnings 5%, instead of Company B, which grows earnings 25%, if the market expected 3% growth out of Company A and 30% growth from Company B. Heck, you'll even see a company that is losing money enjoy a nice bump in its stock price if it lost less money than the market expected. Consider these examples:

Why did enormous earnings growth translate into mediocre stock-price growth for Electronic Arts, Amgen, and Motorola? The answer, of course, is expectations. The market expects a lot from its high-profile companies. It clearly didn't expect as much from small, boring businesses such as Preformed Line and United Stationers.

The merits of stock price
So how does an investor determine what the market expects of a company? Easy. The market has priced its expectations into the company's stock. There are a lot of columns on Fool.com that tell investors that price doesn't matter. And while that's true in some ways, it's also true that all of the information you need to know about expected growth rates, risks, and even share dilution is evidenced in the price. By working backwards in a discounted cash flow model, you can read the market's mind.

Now, you only need to figure out whether the market is wrong.

Landed returns
Sometimes this is easy. Analyst Bill Mann recommended Fairmont Hotels & Resorts (NYSE:FHR) as a Motley Fool Hidden Gems pick because the company's stock price at the time ($33.52) didn't even account for the full value of Fairmont's real estate. Now the company is being bought out, earning subscribers a better-than-30% return.

That was an easy example. It can be far more difficult.

Even better than the real thing
Ctrip.com (NASDAQ:CTRP) was, by some measures, an expensive stock when Fool co-founder Tom Gardner recommended it in Hidden Gems. With its robust P/E north of 40 and a price-to-book ratio in the double digits, Ctrip looked pricey. But Tom thought different. Tom determined that just 30% earnings growth would earn investors massive, market-beating 25% annualized returns. To date, the stock has already moved up 30%.

Why was Ctrip seemingly priced below what Tom expected of it? In one word: risk. Many investors still don't feel confident investing in China, for reasons both political and economic.

You can't value what you can't see
The similarity that Preformed Line, United Stationers, Fairmont, and Ctrip share is that they're all small caps. We focus exclusively on small caps at Hidden Gems partly because we believe that we can find many more small companies that will exceed what the market expects of them. That's because small caps trade fewer shares, are followed by fewer analysts, and receive less media coverage. Without information, the market simply can't assess small companies as efficiently as it can large companies.

That's where we step in . and profit. If you'd like to join us at Hidden Gems as we uncover the very best small-cap opportunities, click here. Our picks are already beating the market by more than 25 percentage points on average, and we expect to do even better over time.

Tim Hanson owns shares of Fairmont Hotels & Resorts. Electronic Arts is a Motley Fool Stock Advisor recommendation. No Fool is too cool for disclosure . and Tim's pretty darn cool.