Big Winners for Small Investors

There's an old story in value investing circles that goes something like this ...

A Midwest billionaire claims he can earn 50% profits year after year, investing ordinary common stocks. Of course, there's always a condition.

And maybe it's just that -- a story. After all, it's a tall order, and it's been hotly debated for years. So, did this guy really make that claim? And if he did, what was his one condition?

Enter a flock of Jayhawks
While we bickered over who said what and when, a class of business students actually did something about it. They traveled from Lawrence, Kansas to Omaha, Nebraska and set up a meeting.

And they asked him: Did he ever really make that "50% per year" guarantee? And more important, would he stand by it? He didn't just confirm it -- he went further.

You'll be surprised how he would do it
To earn that 50% per year -- essentially doubling your money every 20.5 months -- this fellow wouldn't buy the blue-chip consumer giants that made him one of the world's richest men ... or even his own $115 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, this guy would promise us 50% per year ... only if we 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. I know, that sounds nuts. After all, the big money has all the advantages, right? Wrong.

For one thing, even after an absolutely brutal 18 months, pros like Buffett still have way more than $1 million to invest, so they can't mess 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 the usual suspects. Take a look at these names among the most widely owned and heavily traded NYSE stocks.

And over on the Nasdaq? How about Comcast (NASDAQ:CMCSA) and News Corp. (NASDAQ:NWS), each still over $10 billion and trading in the tens of millions a day. On Wall Street, they call this liquidity -- a polite way of saying "the usual suspects buying and selling the same old stocks to each other."

So, if you've got half a billion to put to work this afternoon, you'd better buy something big and forget about the next big thing. But don't expect to be dazzled; even after getting crushed in 2008, 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?
Yes and no. 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. Over the course of 80 or so years, it would have grown to about $2 million. Not bad.

If you'd bought small-cap value stocks instead, you'd have more like $30 million. Of course, the word "value" here is key. In fact, combining the potential of small caps with old-school value is the missing link between big profit potential and Warren Buffett's grind-it-out success.

My old friend and Motley Fool co-founder Tom Gardner hammered this into my head when I worked with him on his Motley Fool Hidden Gems newsletter service. I know firsthand how dramatic the returns can be when you focus on unloved, obscure, and (most important) underpriced small companies.

"Be greedy when others are fearful"
That's something else I learned from Buffett. As painful as it is right now (and I do feel your pain), I think this is a unique buying opportunity for opportunistic small-cap investors. But you're right to be prudent, and you have to pick your spots. Here's a solution.

Try Hidden Gems for free right now and get the top five picks the analyst team thinks are best positioned to make you money right now. I have a hunch these guys can help make you money. I guarantee they'll make you a better investor. If you have less than $1 million to invest, that is.

Best of all, there's no risk for you. If you're not absolutely convinced at any point during the first 30 days, I'll make sure you're not charged a dime. This way you can decide when the market has turned and it's time to move. Even 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 stocks mentioned. Nokia, Pfizer, and Sprint are Inside Value recommendations. Pfizer is also an Income Investor selection. You can view the entire scorecard with your free trial. The Fool owns shares of Pfizer and has a disclosure policy.