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 five blue chips with no bankruptcy concerns, no subprime drama, and no bailout misery:

Source: Yahoo! Finance.

As a whole, the S&P 500 had a 70% 52-week spread, but the volatility story is best seen in individual companies. It's amazing that a company like 3M, whose business model is so steady, has a high that is priced 106% higher than its low.

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 were either bailed out or faced bankruptcy speculation:

Source: Yahoo! Finance.

These spreads border on cartoonish. To translate, in the past year, the investors who bought at the highs spent up to 14 times (Las Vegas Sands) the amount paid by those who bought at the lows.

If groceries fluctuated like that, you'd see some people paying $0.50 for a can of soda, while others would pay enough to make 7-UP sound like the price.

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 larger caps were sprinkled among the 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 past year. By this measure, small caps were 16 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 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 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 portfolio candidates; current stocks include Granite Construction, Blackboard, and Jinpan International. Once a stock gets attractive enough, our team buys it with The Motley Fool's own money. You can see their portfolio candidates, along with 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 does not own shares in any company mentioned. You can follow him on Twitter. Blackboard and Jinpan International are Motley Fool Hidden Gems picks. 3M is a Motley Fool Inside Value selection. Adobe Systems and Ford Motor are Motley Fool Stock Advisor recommendations. Johnson & Johnson is a Motley Fool Income Investor pick. The Fool owns shares of Johnson & Johnson and has a disclosure policy.