Big Winners for Small Investors

Some years ago, an eccentric Midwestern billionaire boasted he could earn 50% a year on a portfolio of ordinary common stocks. You've probably heard of him. Of course, there was a catch.

Or maybe that never really happened. After all, whenever I bring it up, I get bombarded with emails saying it can't be true. So let's put it to rest: Did this guy really make that claim? And if so, what was that one condition?

Enter a flock of Jayhawks
While we debated who said what and when, a bunch of students actually did something about it. They trudged across Kansas and sat down with the guy.

And they asked him, "Did you really make that infamous '50% per year' guarantee? And more importantly, would you stand by it today?" As it turns out, he didn't just confirm that it was true -- he went a step further.

You'll be surprised how he would do it
To earn you 50% per year -- essentially doubling your money every 20.5 months -- this fellow wouldn't buy the stocks that made him a legend, like publishing giant Washington Post (NYSE:WPO). He wouldn't even buy his own $150 billion company.

He'd more likely buy obscure outfits with names you've never even heard of. How do I know? He told us. Remember the catch?

This guy would guarantee he could earn you 50% per year ... only 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 area 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 on Wall Street has all the advantages.

Right? Wrong.

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

That's why you see so much trading volume in the usual suspects. Take a look at these examples I pulled from the most widely owned, heavily searched, and massively traded NYSE stocks.

And over on the Nasdaq? How about Research In Motion (NASDAQ:RIMM), weighing in at $44 billion and trading nearly 23 million shares 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."

In other words, 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; those usual suspects don't have many doubles left in the tank -- much less one every 20 months or so.

But 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 more like $30 million. Of course, the word "value" here is critical. In fact, combining small-cap potential with old-school value is the missing link between big profit potential and Buffett's 50%-per-year promise.

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

Yes, there are bargains out there
Despite last year's pullback and the recent pop, I still believe this a great opportunity for small-cap investors like us. Not long ago, Marty Whitman, one of my favorite money managers, called this the buying opportunity of a lifetime. Warren Buffett loaded up on U.S. stocks last fall.

Same for the team Tom Gardner assembled to continue his Hidden Gems work. So, if you've ever wondered how these guys have managed to outperform the market with little-followed, small-cap companies for six years running, you may never get a better chance to put their ideas into action than this market, right now.

Apparently, the Hidden Gems team agrees with me. The team is putting real money where their figurative mouth is -- to the tune of $250,000. So far, so good. The four stocks they've bought since launching the portfolio in March are up from 20% to 100%.  Fantastic.

Best of all, there's really no risk to you. If you're not convinced at any point during the first 30 days, I'll personally make sure you don't pay a cent. Even Buffett would like that. To learn more about this special free trial offer and to check out the real-money portfolio, click here.

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

Paul Elliott owns shares of Bank of America. You can view the entire Hidden Gems scorecard instantly with your free trial. The Fool has a disclosure policy.