Analysts Hate This Stock

Analysts hate Ambassadors Group.

At least, that's what it looks like -- only three analysts are covering the stock. This company, which arranges domestic and international educational travel for students and professionals, has zero debt on its balance sheet, a return on equity of 23%, and tons of free cash flow.

So what's the problem?
At $200 million, Ambassadors Group is just too small for most analysts to bother with.

See, fortunately for us, analysts don't have time to cover every publicly listed stock. They have to pick and choose -- and they usually choose blue-chip companies such as Visa (NYSE: V) or hotter tech companies like First Solar (Nasdaq: FSLR).

They're big, they're popular, and they're lucrative from an analyst's perspective -- because the first two reasons mean lots of people want to read about them. Just look at how many analysts are covering these big boys:

Data from Yahoo! Finance.

And when analysts watch a company, they don't just watch it -- they scrutinize every detail of its quarterly statements, inspect footnotes, and have the luxury of meeting with management to get the inside scoop.

In other words, they know the stock inside and out. And with so many analysts tearing through company news and reports, it's hard to find a large cap that's undervalued in a normal market. And finding a company that's undervalued, well, that's one of the most essential steps to netting great returns over the long run.

While we can't necessarily say that the companies listed above have done terribly over the last five years because of all the analyst coverage, I'll tell you one thing for certain -- in a normal market, it's hard for a company to beat expectations (which usually drives up stock prices) when so many eyes are watching.

Love the stocks they hate
Why compete with analysts on the big guys, when there are hundreds of small caps that no one has discovered? The fewer people evaluating a stock, the better chance you have to find -- and benefit from -- mispricing.

Many of those ignored small caps eventually turn into the big names -- and they can take you with them. Consider Wal-Mart. When it had its initial IPO, and for years afterward, this retail giant went almost completely unnoticed. But it has experienced a compound annual growth rate of more than 20% over the last 30 years. Just think what an early investment, when it was just a small, overlooked vendor from Arkansas, would have gotten you.

Today, Wal-Mart is a $200 billion company. It may still grow, but it no longer enjoys the same kind of room to grow.

Meanwhile, hundreds of small caps just like Wal-Mart used to be -- with plenty of room for growth -- are still being ignored by Wall Street. Never mind that in the years from 1926 to 2006, small-cap stocks beat large caps by an average of 2.3%.

That may not sound like a lot, but $20,000 invested over 30 years in large caps would have earned 10.4% annually (the S&P average over that time period) -- and you'd have a final investment of $389,136.

If you had invested in small caps, however, that number would be $722,349. Now that's something to get excited about.

Quick, while no one's watching!
Not every small cap should grab your attention. You can find badly run small caps just as often as you can find badly run large caps.

I want to find businesses with clean balance sheets and at least five years of proven track records of returning capital to shareholders. So I look for small-cap companies with the following characteristics:

1. Five-year revenue and net income growth greater than 10%.
2. Debt-to-equity ratios less than 40%.
3. Returns on equity greater than 15%.

Here are a few companies that fit those criteria, in addition to being snubbed by Wall Street:

Data from Capital IQ, a division of Standard & Poor's.

You've probably never heard of half of these companies (I certainly hadn't) -- and that's the point. They're small and little-followed -- so I like my chances against those odds!

There's plenty to be found
The three stocks above have been able to prosper in a very challenging five-year period -- and there's nothing coincidental about the results. Small caps just have more room to grow, and they give you a better shot at a great price.

At Motley Fool Hidden Gems, these are exactly the types of companies we search for. Instead of following $124 billion Coca-Cola (NYSE: KO), we track companies like Ambassadors Group. With an efficient business model, healthy inside ownership, and an attractive growth market, it's a classic Hidden Gems selection.

Companies like this are perfectly poised to take advantage of minimal market exposure, just like you should take advantage of their growth. If you'd like to learn more about Ambassadors Group, or see all of our Hidden Gems research and recommendations, we're offering a free 30-day trial. Click here for more information.

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This article was originally published on October 23, 2009. It has been updated.

Fool contributor Jordan DiPietro owns shares of First Solar. American Express and Coca-Cola are both Motley Fool Inside Value recommendations. First Solar is a Motley Fool Rule Breakers selection. Coca-Cola is a Motley Fool Income Investor recommendation The Fool's disclosure policy loves finding hidden treasures.