There Are No Cheap Stocks

Legg Mason chief investment strategist Michael Mauboussin talks a lot about expectations. What his ideas show 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 that 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 (or no) stock-price growth for Powerwave, QLogic, and DRS Technologies? One answer, of course, is expectations. The market expected so much from these companies that it was more than they could achieve. It clearly didn't expect quite as much from boring businesses such as Pilgrim's Pride, Cato, and Brush Engineered Materials -- and these stocks have simply blown away the market's expectations.

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 telling 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 just need to figure out whether the market is wrong.

Landed returns
Sometimes, this is easy. Analyst Bill Mann recommended First Marblehead as a Motley Fool Hidden Gems pick because the company's stock price at the time ($35.50) didn't account for the rapid growth at First Marblehead and in the student-loan industry -- a result of some management missteps. The company has since recovered; it earns subscribers a better than 60% return.

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

Even better than the real thing
Ctrip.com 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. He determined that just 30% earnings growth would earn investors massive, market-beating 25% annualized returns. To date, the stock has already moved up 65%.

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 Pilgrim's Pride, Cato, Brush Engineered Materials, First Marblehead, 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 where we 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 17 percentage points on average, and we expect to do even better over time.

This article was originally published on March 15, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. No Fool is too cool for disclosure.