Thinking you're smarter than the market can be dangerous. And while every investor has gotten burned at one time or another, the best investors learn valuable lessons from their losses.
One of the most important may be that the market is, in fact, pretty smart. Yes, bizarre valuations happen from time to time, but with 15-plus highly educated Wall Street analysts covering the moves of mega caps such as Johnson & Johnson
In other words, the market is mostly efficient. The good news for individual investors is that it's more efficient in some segments than others. You're more likely to find mispricings when you're looking where no one else is ... at small-cap stocks.
But be warned: Mispricings happen on both sides of a stock. Small companies can get wildly overvalued or wildly undervalued. If you're going to invest in this profitable sector, you need to know how to tell the difference.
Betting on the wrong horse
In 1993, upstart footwear company Timberland
Many investors were enticed by Timberland's superb revenue growth. The company transformed from a niche outdoors outfitter to a popular consumer brand. Indeed, revenue grew 29% in 1992 and 44% in 1993.
But something was wrong.
A glance at Timberland's 1993 cash flow statement revealed that the company was piling up inventories and accounts receivable. Its products simply weren't as popular as the market thought they were, and the company wasn't getting paid in cash for the earnings it was reporting. To make matters worse, Timberland loaded up on debt, increasing its long-term borrowings from $41.5 million to $90.8 million "in support of sales growth."
Although the market began to see these red flags at the end of 1993, Timberland's stock still finished the year up more than 170%.
The following year, the financial woes continued, alarm bells sounded in the market, and Timberland's stock plummeted 59%.
Timberland's stock has recovered since then, but the example illustrates just how the market can overreact to both good and bad news -- and how that can cause wild price swings in the shares of underfollowed small caps.
Fortunately, just as the market can be late to see worsening financial performance at small caps, it often misses improving financial performance. That's where you, as a small investor, have the opportunity to profit.
Back in December 1997, for instance, Urban Outfitters
Eventually, the market caught on. Since the beginning of 1998, Urban Outfitters has returned more than 1,100%, and Green Mountain has returned an astounding 3,500% -- making it one of the top 10 stocks of the past 10 years.
The market can be wrong temporarily, but it's never wrong for long. That's why it's important for small-cap investors to learn how to separate the overvalued hype stocks from the undervalued winners. The subsequent performance of Urban Outfitters and Green Mountain Coffee are proof positive that small investors can capitalize on the market's mistakes.
To recap, as a small individual investor, the secret to taking advantage of irrational markets is finding stocks that are:
- Financially sound
- Led by dedicated founders with significant ownership
These are exactly the kind of stocks we look for at Motley Fool Hidden Gems, the Fool's small-cap investing service. Led by Fool co-founder Tom Gardner, Hidden Gems picks are outperforming the market by 22 percentage points on average since inception in July 2003.
You can get full access to all of the Hidden Gems recommendations with a free 30-day trial to the service. There's no obligation to subscribe. To learn more, click here.
Fool contributor Todd Wenning needs his phone to work in more places, like Cincivaleaphilaburg. He does not own shares of any companies mentioned in this article. Johnson & Johnson is a Motley Fool Income Investor pick. The Fool's disclosure policy gets its swell on at the gym.