Big Winners for Small Investors

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

A Midwest billionaire claims he can earn you 50% profits year after year, investing in nothing other than ordinary common stocks. Of course, there's a condition. Intrigued? I was.

Or maybe that's just that -- a story. After all, 50% annual returns is a tall order, and it's been debated for years. So, did this guy really make that claim? And if he did, what was that 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 kicked their way from Lawrence, Kansas to Omaha, Nebraska and set up a meeting with this fellow.

And they asked him: Did he ever really make that "50% per year" guarantee? And more important, would he stand by it today? 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 guy wouldn't buy the blue-chip consumer giants that made him the world's richest man ... or even his own $130 billion company.

He'd buy obscure companies with names you've probably never heard of. 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 regular Joes like us have an advantage over the pros.

Why Warren Buffett wishes he were you
You knew it was Buffett, didn't you? Of course. 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, even after the market collapse, most pros 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 inadvertently buying a controlling stake in the firm.

That's one reason why you see so much trading volume in what I call the usual suspects. Take a look at these familiar names among the most widely owned and heavily traded Nasdaq stocks.

And over on the NYSE? How about Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM), still weighing in at $100 billion plus and trading more than 70 million shares a day. On Wall Street, they call this liquidity -- a polite way of saying "the good old boys 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; 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. A company called Ibbotson Associates tracks stock returns by "style" and market cap. According to Ibbotson, 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 key. In fact, you could argue that combining the storybook potential of small caps with old-school valuation 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. After working with Tom, 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 feel your pain), I truly think we'll look back on this market as a godsend for opportunistic small-cap investors. In other words, if you've ever wondered how Tom Gardner's handpicked Hidden Gems team has beaten the market six years running with small-cap value stocks, now's the time to find out.

In fact, the team is so convinced that now is the time to buy, they are investing $250,000 of real money in their favorite small-cap picks. If you like, you can look on as they build their portfolio in real time. I have a hunch it'll help make you 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 for you. If you're not absolutely convinced at any point during the first 30 days, I'll personally make sure you're not charged a dime. Of course, by then you'll have already seen all the premium content and the entire portfolio, but I'm ok with that, too. To learn more about this free trial offer and how to view the Hidden Gems portfolio, click here.

Already subscribe to Hidden Gems? Log in at the top of this page.

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

Fool writer Paul Elliott doesn't own any stocks mentioned. You can view the entire scorecard with your free trial. NVIDIA is a Motley Fool Stock Advisor recommendation. Google is a Rule Breakers pick. The Fool has a disclosure policy.