Big Winners for Small Investors

A well-known investor once claimed he could earn you 50% per year on a portfolio of ordinary common stocks. Of course, there was a condition.

Or maybe that's an urban legend. After all, folks have argued the point for years. But what if this guy really did make that ridiculous claim? And if so, what was that one condition?

Enter a flock of Jayhawks
While we bickered over who said what and when, a bunch of business school kids did something about it. They marched across Kansas and into Nebraska and demanded to chat with this gentleman.

When he agreed, they simply asked him: Did the guy commonly known as the world's greatest investor ever really make that "50% per year" guarantee?

And, more importantly, would he stand by it? As it turns out, he didn't just confirm that it was all true -- he went one 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 -- he wouldn't buy the blue-chip consumer giants like American Express (NYSE:AXP) that made him a legend, or even his own $150 billion company.

No, he'd buy obscure companies with names you've probably never even heard. How do I know that? He told us. Remember that one condition I mentioned earlier?

Well, this guy would guarantee he could earn you that 50% per year ... only if he had less than $1 million to invest. That's because he would invest in undiscovered, thinly traded small companies -- the one niche in the market where small investors like us have an advantage over the pros.

Why Warren Buffett wishes he were you
I imagine you guessed it was Buffett. Well, can you guess why he wishes he were you? Because he has too much money. Yeah, I know that sounds nuts. After all, everybody knows that the big money on Wall Street has all of the advantages, right? Maybe not.

For one thing, most pros have way more than $1 million to put to work, so they can't mess with a little energy company like Southwestern Energy. Well, maybe they can now -- but not 10 years ago, when the stock started the 2,911% run-up that made it one of the market's 10 best stocks.

Of course, that's one big reason -- a lack of courage and originality is another -- why you see so much trading volume in the usual suspects. Don't believe me? Take a look at the names I found among the most heavily traded Nasdaq stocks:

And over on the NYSE? How about Pfizer (NYSE:PFE), trading nearly 50 million shares a day. On Wall Street, they call this liquidity. I call it a polite way of saying "the good old boys buying and selling the same old stocks to each other."

Either way, if you have half a billion to put to work this afternoon, you'd better buy one of those, and forget the next big thing. But don't expect to be dazzled by your returns -- almost by definition, the 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 haul. 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, give or take. Not bad.

If you'd bought small-cap value stocks instead, you'd have more like $30 million. Of course, that's a long time to be invested. But then, isn't that the point? Of course, the word "value" is critical, too. In fact, combining small-cap potential, patience, and old-school valuation may be the missing link between big profit potential and Buffett's 50% boast.

Motley Fool co-founder and small-cap guru Tom Gardner hammered this lesson into my head back when I worked with him on The Motley Fool's market-beating Hidden Gems newsletter service. So I know firsthand how rewarding the returns can be when you focus on unloved, obscure, and (most importantly) underpriced small companies.

We've had a heck of a run
So if you're more comfortable waiting for a pullback before diving into small-company stocks, I can respect that. But don't wait too long. I still think this market is a lifetime buying opportunity for opportunistic, long-term investors. But you're right to pick your spots.

Here's a perfect compromise. Sample Motley Fool Hidden Gems for free, and with no obligation, right now. You can check out the two top small companies the expert analyst team thinks are best positioned to make you money. While you're at it, jot down the stocks they are buying for their real-money portfolio (so far, every single pick is in the green) -- so you'll have them when you're ready to buy.

But again, I wouldn't sit too long and get caught on the sidelines. I have a hunch the guys at Hidden Gems can help make you some 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. If you're not absolutely convinced at any point during the first 30 days, I'll make sure you don't pay a dime. And no matter what you decide, you'll be ready to move when you decide the time is right. Even Buffett would be proud. To learn more about this special free trial offer, click here.

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

Paul Elliott owns shares of Pfizer. Intel, American Express, and Pfizer are Motley Fool Inside Value picks. You can view the entire scorecard with your free trial. The Fool owns shares of American Express and Intel as well as covered calls on Intel and has a disclosure policy.