You Can't Win in This Market

To look at my email inbox is to wonder whether:

a. My friends are all exiled Nigerian bankers with loads of excess cash.

b. I'm a freak for cheesy American Idol knock-offs.

c. Hedge funds and short-sellers are out to destroy me.

Since neither "a" nor "b" have much to do with investing -- unless, that is, you're betting on the burgeoning futures market built around the odds of Lindsay Lohan next landing in jail or rehab -- let's focus on "c". Should I be paranoid about hedge funds and short-sellers? A reader thinks so. Here's what he wrote to me recently: "Please help us smaller investors to fight against the naked short selling and stock manipulations in our market. Small investors have no chance to win at all." [Emphasis added.]

Really? I beg to differ:

Sources: Nasdaq Reg SHO list, Yahoo! Finance, shortsqueeze.com.

Yes, Virginia, there is a Santa Claus ... and his name is Mr. Market
Each one of these stocks has spent months, and in some cases years, on the Nasdaq's Reg SHO list, which identifies firms commonly thought to be the subject of short attacks. Yet owning any one of them over the past year would have helped you to crush the market in grand fashion.

Now, does that mean you should buy every stock on the Reg SHO list? Certainly not. There are some pretty bad businesses on that list. Closeout retailer Overstock, though improving, may be one, thanks to a long and sordid history of capital destruction.

My point is this: While it's true that prices can't move up when there are more sellers than buyers, given time, excellent businesses always draw more buyers than sellers eventually.

And that spells opportunity for you, the belled-cap small investor who doth call himself Fool.

Here's why. Short sellers tend to have a very short timeline for investing. As they should; there's no limit to the losses for the short-seller that bets against a stock that turns north.

Thus, when they err by shorting companies with outstanding fundamentals, they create temporary price depressions that enable massive long-term returns. Behold:

Sources: shortsqueeze.com, Yahoo! Finance.

Still not convinced? Check out the long-term returns for Jacobs Engineering, Chesapeake, and BlackRock. All three have throttled the S&P 500 on their way to multi-bagger returns. They also have a history of being targeted by short sellers.

Small caps bite back
Therein lies the single greatest advantage of the small investor: time. By staying invested longer than others will -- certainly longer than the shorts will -- you can profit from other investors looking only to make a quick buck. Three to five years is an ideal time frame for Seth Jayson and Bill Mann, who together co-host Hidden Gems, the Fool's market-beating small-cap service.

Their reasoning? Small caps are rarely followed as closely as their larger brethren and, given time, are more likely to be undervalued or unfairly shorted.

And remember: It was 10 small caps that went on to become the 10 best stocks of the past decade. Via Hidden Gems, Seth and Bill are hunting for the next 10.

So let the Chicken Littles cluck all they want, Fool. You, the small investor, have no chance in this market? Poppycock.

This article was originally published on December 7, 2007. It has been updated.

Fool contributor and Rule Breakers writer Tim Beyers didn't own shares in any of the stocks mentioned in this article at the time of publication. Chesapeake Energy is an Inside Value pick. The Motley Fool's disclosure policy was never small time. It just went big time.