Big Winners for Small Investors

A few years back, a Midwestern billionaire boasted that 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 kids from the University of 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 importantly, would he stand by it today?

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 $150 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 largely 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 large-cap stocks. Take a look at these stocks among the most widely owned and heavily traded on the NYSE.

Data from Yahoo! Finance.

And over on the Nasdaq? Check out eBay (NASDAQ:EBAY) and Cisco (NASDAQ:CSCO), trading nearly 17 million shares and 45 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."

Whatever you call it, 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. 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 76 years later. 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 critical. In fact, I'm more and more 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 helped him launch 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. I was saying that back in March, and I still think it’s true. I don’t blame you for picking your spots, but this market is still a great opportunity for long-term, small-cap investors like us. Remember, small caps perform notoriously well coming out of recessions.

By all indications, Tom 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. Eighty percent of their positions are in positive territory -- including gains of 75% and 112%. Fantastic.

Best of all, you can check it out for yourself without any risk whatsoever. Check out the entire Hidden Gems service. If you're not convinced at any point during the first 30 days it’s for you, 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. The Motley Fool owns shares of American Express. eBay is a Stock Advisor recommendation. Motley Fool Options recommended a bull call spread on eBay. Pfizer, Nokia, and American Express are Inside Value recommendations. The Fool has a disclosure policy.