These Are the Market's Biggest Opportunities

Volatility equals opportunity.

It is perhaps THE fundamental investing lesson; it's what Ben Graham was talking about when he referred to the vagaries of Mr. Market, and it's what people really mean when they repeat the silly phrase "buy low, sell high."

Maybe you already get it, but most investors will never learn that lesson. I know I struggle with it.

Why? Because no matter how many bubbles and bursts we live through, we all get juiced on the way up and terrified on the way down. We confuse our buy opportunities with our sell opportunities.

But if we can keep our heads when all about us ...
Numbers are clearer than words. An easy way to gauge volatility is to compare 52-week highs and lows. The bigger the spread -- i.e., the percentage difference from the low to the high -- the greater the volatility.

Let's start with the most benign example. Here are four blue chips with no bankruptcy concerns, no subprime drama, and no bailout misery:

As a whole, the S&P 500 had a 90% 52-week spread, but individual companies are where the volatility story is best seen. It's amazing that a company like Pepsi, whose business model is so steady, has a high that is priced 72% higher than its low. Ditto Disney's 130% difference.

A greater opportunity
There have certainly been opportunities in the blue-chip space, but let's take it up a notch or three. Check out the spreads on these companies that all faced speculation about possible bankruptcy or nationalization:

These spreads border on cartoonish. To translate, in the past year, the investors who bought at the highs spent up to 30-some times (Las Vegas Sands) what those who bought at the lows paid.

If groceries fluctuated like that, you'd see some people paying $0.50 for a can of 7-UP while others paid more than $10.

But wait, it gets better ...
Now here's the kicker. I ran a screen to find the most volatile stocks (i.e., those that presented the best opportunities for outrageous profits) over the past year. None of these companies cracked the top 10!

Why?

Because my list was dominated by smaller companies -- even though I excluded the potentially fly by-night over-the-counter companies I've warned you in the past to avoid. Yes, a few large caps were sprinkled among the top 50 most volatile, but the vast majority were from small-cap land.

The market's biggest opportunities
To further test my hypothesis that smaller companies offer the market's biggest opportunities, I compared the spread volatility of large caps (via the S&P 500) with the spread volatility of small caps (via the Russell 2000) over the last year. By this measure, small caps were 32 percentage points more volatile!

So how does this help us? I believe the market will continue to be quite volatile over the next year as investors hem and haw about the state of our economy. Since volatility equals opportunity, it's a great time to add some more small-cap companies to our watch lists.

As the market continues to zigzag, we'll have the ability to pick up some of our favorite companies at steep discounts. But only if we rise above the panic by identifying promising stocks early and patiently waiting for the market to deliver tasty prices.

If you want some help constructing your small-cap watch list, I invite you to check out our Motley Fool Hidden Gems newsletter service. The team scours the small-cap universe for watch-list candidates; current stocks that they're waiting for cheaper prices on include Granite Construction, Under Armour, and Jinpan International. Once a stock's price gets attractive enough, they buy it with The Motley Fool's own money. You can see their watch list and their entire real-money portfolio by clicking here for a free 30-day trial. There's no obligation to subscribe.

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This article was originally published Aug. 14, 2009. It has been updated.

Anand Chokkavelu owns shares of Disney and Microsoft. Disney is a Motley Fool Stock Advisor recommendation. Disney and Microsoft are Inside Value selections. PepsiCo and United Parcel Service are Income Investor picks. Granite Construction, Under Armour, and Jinpan International are Hidden Gems picks. Under Armour is also a Rule Breakers selection, and The Motley Fool owns shares of Under Armour. The Fool has a disclosure policy.