A Broken Stock Full of Promise

Being wrong is the most sobering aspect of investing. Even the best investors get dunked by unanticipated events or a market that just plain disagrees with them.

If that's happened to you, you're not alone. In fact, such an experience has probably made you a better investor. I find myself in such a situation now, and while I normally wouldn't mind, this one's a little more awkward than most.

What's the stock?
The stock in this case is $1.4 billion Bermudan reinsurer Montpelier Re (NYSE:MRH). Since Bill Mann recommended this stock in our Hidden Gems small-cap newsletter at $34 and change, it's been absolutely pummeled by an active hurricane season. Estimated losses were close to $800 million, the company's dividend was reduced, and book value declined. The stock, of course, followed suit. It dropped to $20, then $18, and now down to $16.

I'm not embarrassed to tell you that I bought shares a few times between $16 and $18. Those shares are mostly in the red today.

Now here's what makes this awkward: I recommended that my father-in-law do the same.

He hates you now, doesn't he?
Thankfully, my father-in-law is a good guy, and he hasn't sent me a bill -- just resorted to some good-natured ribbing. I also think he trusts me (or just really wanted to pass his daughter off).

I still feel bad. Losing money is not fun, and it's even worse when somebody loses money because of you. But I'm not selling Montpelier Re. The stock continues to possess four of the core tenets we look for at Motley Fool Hidden Gems:

1. Experienced management.
2. Recent insider buying.
3. A broken stock price.
4. A catalyst in rising premiums and less-active hurricane seasons going forward.

These are the makings of what could be an incredible turnaround story, and they're among the traits that master investors such as Peter Lynch and Warren Buffett sought in their stocks. Although the market disagrees with me right now, I remain optimistic. As Buffett noted, the best time to be greedy is when others are fearful.

If Montpelier Re is such a value, why hasn't the efficient market already gobbled it up?
Great question. Two points here:

1. Montpelier Re is more sensitive than most to an unknowable variable: weather patterns. It's not a sure thing, and the market doesn't know what to expect.
2. Montpelier Re trades fewer than 1 million shares per day on average, and it's covered by just eight analysts.

Remember, it's easiest to make money where no one else on Wall Street is looking. The bigger a company, the better it's covered and the more efficient its price. Small caps like Montpelier Re are one of the market's most forgotten areas. Just take a look at the disparity between the most heavily traded small caps and large caps:

While volume can vary from day to day, the bigger story here is how few analysts cover even the most active small caps. That's why we have an opportunity there as individual investors.

The Foolish bottom line
Small caps carry the risk of getting a whole lot smaller, but because they're small, they also have growth potential far beyond that of the market's giants. Indeed, the 10 best stocks of the past 10 years were all obscure small stocks, and according to data from Fama and French, small-cap value stocks have outperformed the broader market by more than five percentage points since 1927.

I think Montpelier Re is a stock with potential, and at Hidden Gems, we identify two similarly promising small caps each month for our community members. To date, our recommendations have thumped the S&P 500 to the tune of 25 percentage points.

Even if you don't want to be a full-fledged small-cap investor, every portfolio should have at least some exposure to the great growth that small firms offer. If you'd like to learn more, feel free to tour our community for 30 days by clicking here. There's no obligation to subscribe, and while you'll find that we're not right 100% of the time, you'll see that our methodology helps us be right -- really right -- more often that not.

Tim Hanson owns shares of Montpelier Re. Microsoft is a Motley Fool Inside Value recommendation. Montpelier Re is also a recommendation of Motley Fool Stock Advisor. No Fool is too cool for disclosure . and Tim's pretty darn cool.