The Stocks That Hedge Funds Buy

Believe it or not, there are companies that the big-money firms on Wall Street don't know about, don't have thousands of pages of research or extensive cash flow models for, and don't have an idea whether to buy or not.

These are among the few stocks in which Wall Street doesn't hold an informational advantage over individual investors like you and me.

Which stocks are they?

Small caps.

Advantages in investing small
The key to making winning investments is to see value before anybody else does. That's a lot more difficult to do in large energy stocks such as ExxonMobil (NYSE:XOM) or Chevron (NYSE:CVX) than it is in a smaller energy stocks such as TransMontaigne (NYSE:TMG) or Dawson Geophysical (NASDAQ:DWSN). That's because while everybody on Wall Street has an opinion on Exxon and Chevron, barely anyone has even heard of TransMontaigne or Dawson.

Because very few professionals are keeping tabs on either TransMontaigne or Dawson, they don't see that both would benefit mightily from sustained demand for oil. Motley Fool Hidden Gems analyst Bill Mann, however, did just that. His recommendation of TransMontaigne is up more than 40% in just four months, after Morgan Stanley and SemGroup engaged in a bidding war for its undervalued assets. Dawson, on the other hand, is up just 1% since Bill's recommendation, but it stands to make a lot of money as more and more big oil companies hire the seismic data firm to help them find oil.

That's the profit potential in paying attention to the companies that no one else is paying attention to ... yet.

Learn from the hedge funds
As more and more money flows into our markets, it's becoming harder for even the best investors to find companies in which they hold an informational advantage. That's one of the reasons why some of the market's sharpest hedge funds have been moving to small caps. As The Wall Street Journal recently reported:

"[H]edge funds are flocking to small caps in part because they aren't followed closely by investment bank analysts, presenting hedge funds with opportunities to find companies off Wall Street's radar screen."

According to the Citigroup analyst cited in the article, while companies with less than $10 billion in float compose only 28% of the Russell 3000 index, these small fries make up 59% of hedge fund holdings.

While that may sound shocking, it shouldn't be. Hedge funds know that small caps are simply some of the best stocks to make big money in.

The downside of gains
Unfortunately, all of this hedge-fund interest in small caps has pushed up prices. Small caps have beaten large caps three years in a row, and the Russell 2000 small-cap index is already thumping the S&P 500 this year. In other words, it's become just a little more difficult to find fairly priced or underpriced small companies. As Fool co-founder Tom Gardner observed recently, the smaller the company, the more expensive it seems to have become on a P/E basis.

But that doesn't mean it's time to abandon small caps. Large companies are still heavily followed and more efficiently priced than the little guys, and that fact will never change.

What's a Fool to do?
Instead, individual investors just need to work a little harder to find tiny companies in which they can gain an information advantage. At Hidden Gems, we recently started watching two health-care micro caps -- Healthstream (NASDAQ:HSTM) and National Research (NASDAQ:NRCI) -- that meet some of our core investment criteria:

1. Substantial insider ownership.
2. A devoted founder/CEO at the helm.
3. A wide market opportunity.

While both of these firms look promising as health-care spending continues to rise at its fastest rate ever, there aren't more than a handful of analysts covering either of them. Wall Street, on the other hand, is watching $70 billion UnitedHealth's (NYSE:UNH) every move. That's worthwhile, of course, because UNH will rake in hefty profits as health-care spending continues to rise at record rates. Still, individual investors like you and me can find better returns by looking smaller.

The Foolish bottom line
The key to successful investing is to hold an advantage over other investors. You can gain that advantage by becoming a smart small-cap investor.

If you'd like to learn more, join us a guest at Hidden Gemsfree for 30 days. You'll get specific stock recommendations, plus daily updates and tips to help you find promising small caps on your own.

There's no need to compete with Wall Street's nearly limitless resources when you can simply play where they don't.

Tim Hanson owns shares of Dawson Geophysical. UnitedHealth is a Stock Advisor recommendation. No Fool is too cool for disclosure ... and Tim's pretty darn cool.