Big Winners for Small Investors

A few years back, a Midwestern billionaire boasted he could earn 50% per year on a portfolio of ordinary common stocks. As usual, there was one condition.

Or maybe that's just a Wall Street legend. After all, it's been hotly debated for years. So, you tell me: Did this guy ever really make that claim? If so, would he 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 from Kansas actually did something about it. They went straight to the source, and 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 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. You read that right, less. 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 on Wall Street has all the advantages, right?

Maybe not. 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? Check out eBay (NASDAQ:EBAY) and Cisco (NASDAQ:CSCO), trading nearly 17 million shares and 58 million shares a day respectively. 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 like everybody else. 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, at least over the long term. 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 76 years later. Not bad.

If you'd bought small-cap value stocks instead, you'd have more like $33 million. Of course, the word "value" here is critical. In fact, I'm convinced that combining small-company potential with old-school valuation may be the missing link between big profit potential and Warren 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, this brutal recession is an opportunity for long-term, small-cap investors like us. It's a value investor's dream, and small caps perform notoriously well coming out of recessions.

By all indications, Gardner's Hidden Gems team agrees with me. The team is putting real money where its mouth is -- to the tune of $250,000. So far, so good. Seven of the eight stocks they've bought since launching the portfolio in March are beating the market -- including gains of 43% and 142%. 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 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. The Motley Fool owns shares of American Express. eBay is a Stock Advisor recommendation. Pfizer, eBay, and American Express are Inside Value recommendations. The Fool has a disclosure policy.