The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent. -- Seth Klarman, founder of the Baupost Investing Group
I learned early on that I come from contrarian stock. At 10 years old, I asked my dad why he didn’t buy a nice new car like the other dads in the neighborhood -- after all, he worked hard days and weekends and could have afforded it. He looked at me and said, "Son, cars are depreciating assets."
Despite examples to the contrary, however, we as humans are hardwired not only to care what other people think but to follow the herd in almost every scenario.
Especially your neighbors
Consider the following experiment conducted by Robert Cialdini, professor of both psychology and marketing.
He wanted to find out what would persuade people to conserve energy, so he put leaflets in people's doorways with different messages. One control group received no leaflets; one group received leaflets with facts about how energy conservation helps the environment; another group received information on how much money they could save; and one group received leaflets that said, “The majority of your neighbors are conserving energy.” Later, they checked the gas meters to see who had, in fact, changed their energy consumption.
I’m sure you see where I’m going with this -- the most effective leaflet was the one telling people that their neighbors were conserving energy. As Cialdini says, people will almost always do things they know or believe other people are doing. Think about how many times you’ve stopped and looked up at the sky just because other people were doing it.
That's why bubbles are so devastating -- we tend to get caught up in the excitement, buying shares of Yahoo!
Far from the madding crowd
There are some great reasons to practice going against the grain -- especially when it comes to investing.
Following stocks that everyone else is following hardly gives you much of an advantage -- you’re forced to compete against not only thousands of other investors, but hundreds of scrupulous Wall Street analysts.
On the other hand, tracking stocks that are typically ignored -- i.e., small-cap stocks -- allows you to find mispricing situations, and once you can identify a great company that’s undervalued -- well, you’ve just hit a gold mine.
For example, I bet most of your neighbors haven’t heard of Dynamic Materials
A decade ago it was a penny stock, but today it’s experienced almost 40% annualized growth. It's had revenue growth of more than 30% a year for the past five years, great competitive advantage, and consistent returns on equity.
You simply can’t find that type of growth from companies your neighbors have already heard of -- blue-chip stocks like Pfizer
Keep it in the family
To find the stock champion of the next 10 years, you’ll need to avoid the herd -- and look where your neighbors aren't. That means seeking out small-cap stocks that are being ignored, then finding the ones that have excellent growth, return money to shareholders, and are trading cheaply.
For example, here are some lesser-known small caps that have the same qualities Dynamic Materials had before it saw those enormous gains:
|
Market Cap |
P/E Ratio |
5-Year Annualized Revenue Growth (TTM) |
Return on Equity (TTM) |
|
|---|---|---|---|---|
|
Pinnacle Airlines |
$126 million |
3.9 |
10% |
47.6% |
|
Innophos Holdings |
$445 million |
2.5 |
18%** |
94.9% |
|
Vascular Solutions |
$143 million |
7.7 |
32.6% |
76.6% |
*Data taken from Capital IQ as of Oct. 16, 2009, and from Yahoo! Finance. TTM=trailing 12 months. **Only 3-year growth was available.
I’ll be honest -- not all small-cap stocks are going to be a perfect fit. But if you have the guts to pick the less popular stocks, your portfolio will surely reap some tremendous benefits.
Those are the kinds of stocks we buy for our Hidden Gems real-money portfolio-- and our picks are beating the market. If you’re interested in seeing the stocks our analysts are recommending, just click here for a free, 30-day trial. There's no obligation to subscribe.
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Fool contributor Jordan DiPietro owns no shares of the stocks above, but will always be grateful for his father’s wise advice. Dynamic Materials and Innophos Holdings are Motley Fool Hidden Gems recommendations. Amazon.com is a Stock Advisor selection. Pfizer and Wal-Mart are both Inside Value picks. The Fools disclosure policy doesn’t worry about keeping up with the Joneses.
