Big Winners for Small Investors

A Midwest billionaire once claimed he could earn 50% per year on a portfolio of ordinary common stocks. Of course, there was one condition.

Or maybe that's just a Wall Street legend. After all, it's been debated for years. So, you tell me: Did this guy ever really make that claim? If so, could he actually do it? And what was that one condition?

Enter a flock of Jayhawks
While we argued over who said what, a bunch of meddling kids actually did something about it. They marched out of Kansas and went straight to the source. And they asked him: Did the man known as the world's greatest investor really make that guarantee? And more important, would he stand by it today?

As it turns out, he didn't just confirm it was true -- he went a giant step further.

You'll be surprised how he would do it
As it turns out, to earn that 50% per year -- essentially doubling your money every 20.5 months -- this guy wouldn't buy the blue-chip consumer giants like American Express (NYSE:AXP) that made him a legend.

He wouldn't even buy his own $140 billion company. He'd buy obscure companies with names you've probably never heard. How do I know? He told us. Remember that one condition?

Well, he would only guarantee you 50% per year ... if he had less than $1 million to invest. That's because he would be loading up on undiscovered, thinly traded small companies -- the one spot in the market where individual investors like us have an advantage over the pros.

Why Warren Buffett wishes he were you
You knew it was Buffett, didn't you? Well, can you guess why he wishes he were you? Because he has too much money. Yeah, I know that sounds nuts. After all, the big money has all the advantages, right? Wrong.

For one thing, the pros have way more than $1 million to invest, so they can't mess around with great "small" companies -- at least not without risking running up the price or buying a controlling stake in the firm.

That's one reason why you see so much trading volume in familiar names and big-cap stocks. Take a look at these names among the most widely owned and heavily traded NYSE stocks.

And over on the Nasdaq? How about eBay (NASDAQ:EBAY), weighing in at $18 billion and trading nearly 20 million shares a day? On Wall Street, they call this "liquidity." I call it, "the usual suspects buying and selling the same old stocks to each other."

Still, if you've got half a billion to put to work this afternoon, you'd better buy something big. But don't expect to be dazzled; those usual suspects don't have many doubles left in the tank -- much less one every 20 months or so.

Wait a minute! Aren't small companies risky?
Not necessarily. Ibbotson Associates tracks stock returns by "style" and market cap. You could have invested $1,000 in Ibbotson's large-cap universe back in 1927, and you'd have about $2 million today. Not bad.

If you'd bought small-cap value stocks instead, you'd have $33 million. Of course, the word "value" here is critical. In fact, I'm convinced that combining small-cap potential with old-school value may be the missing link between big profit potential and Buffett's legendary returns.

Motley Fool co-founder Tom Gardner hammered this lesson into my head years ago when I worked with him on his Motley Fool Hidden Gems newsletter. So, I know firsthand how fantastic the returns can be when you focus on unloved, obscure, and (most importantly) underpriced small companies.

"Be greedy when others are fearful"
That's something else I heard from Buffett. If you ask me, the "Crash of 2008" is an opportunity for long-term, small-cap investors like us. It's a value investor's dream. In other words, if you've ever wondered how Tom's team of analysts at Hidden Gems has beaten the market more than five years running with small-cap value stocks, now's the time to find out.

Especially since you can give Hidden Gems a try for free for a full month, and get The Motley Fool's top five small-cap value picks for new money right now. I have a hunch that Hidden Gems can help make you some money. I guarantee it'll make you a better investor.

If you have less than $1 million to invest, that is. Best of all, there's no risk. If you're not convinced at any point during the first 30 days, I'll personally make sure you don't pay a dime. Buffett would be proud. To learn more about this free trial offer, click here.

This article was originally published on Feb. 10, 2006. It has been updated.

Paul Elliott  doesn't own any of the stocks mentioned. You can view the entire Motley Fool Hidden Gems scorecard with your free trial. Paul doesn't own any stocks mentioned. The Motley Fool owns shares of American Express and Pfizer. eBay is a Stock Advisor recommendation. Pfizer is an Income Investor and an Inside Value selection. American Express is an Inside Value recommendation. The Fool has a disclosure policy.