Big Winners for Small Investors

A famous businessman and legendary investor once claimed he could earn 50% per year on a portfolio of ordinary common stocks. Of course, there was a condition.

Or maybe that's a Wall Street legend. After all, investors and students have argued whether any of this ever happened for years. But what if this guy really did make that outrageous claim? And if he did, what was that one condition?

The plot thickens ...
While we bickered over who said what and when, a class of Midwestern business school kids did something about it. They drove across Kansas and into Nebraska and demanded an audience with this gentleman.

When he agreed to the meeting, they asked him: Did the guy commonly known as the world's greatest investor ever really make that "50% per year" guarantee?

And, more importantly, would he stand by it?

You'll be surprised how he would do it
To earn you 50% per year -- essentially doubling your money every 20.5 months -- he wouldn't buy the blue-chip consumer giants like American Express (NYSE: AXP) that made him one of the world's richest men, or even his own $180 billion company.

No, he'd buy obscure companies with names you've probably never even heard. How do I know that? He told us. Remember that one condition I mentioned earlier?

Well, this guy would guarantee he could earn you that 50% per year ... only if he had less than $1 million to invest. That's because he would invest in undiscovered, thinly traded small companies -- the one niche in the market where small investors like us have an advantage over the pros.

Why Warren Buffett wishes he were you
I imagine you guessed who it was. Well, can you guess why he wishes he were you? Because he has too much money. I know that sounds nutty. After all, everybody knows that the big money on Wall Street has all of the advantages, right? Maybe not.

For one thing, most pros have way more than $1 million to put to work, so they can't mess with a little energy company like Southwestern Energy. Well, maybe they can now -- but not 10 years ago, when the stock started the 2,911% run-up that made it one of last decade's 10 best stocks.

Of course, that's one of a few big reasons why you see so much trading volume in the usual suspects. Don't believe me? Take a look at the names I found among the most heavily traded Nasdaq stocks:

And over on the NYSE? How about Pfizer (NYSE: PFE), at nearly $150 billion and trading 50 million shares a day. On Wall Street, they call this liquidity. I call it a polite way of saying "the good old boys buying and selling the same old stocks to each other."

Either way, if you have half a billion to put to work this afternoon, you'd better buy one of those, and forget the next big thing. But don't expect to be dazzled by your returns -- almost by definition, these 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 haul. Ibbotson Associates tracks stock returns by "style" and market cap. You could have invested $1,000 in Ibbotson's large-cap universe back in 1927, and you'd have had about $2 million 75 years later, give or take. Not bad.

If you'd bought small-cap value stocks instead, you'd have had more like $30 million. Of course, that's a long time to be invested. But then, isn't that the point? Of course, the word "value" is critical, too. In fact, combining small-cap potential, patience, and old-school valuation may be the missing link between big profit potential and Buffett's 50% boast.

Motley Fool co-founder and small-cap guru Tom Gardner hammered this lesson into my thick skull when I worked with him on the market-beating Motley Fool Hidden Gems newsletter service. So I know firsthand how rewarding the returns can be when you focus on unloved, obscure, and (most importantly) underpriced small companies.

We had a heck of a run
But things have cooled off a bit. Still, if you're more comfortable waiting for another pullback before diving into small-company stocks, I can respect that. But don't wait too long. I still think this market is a buying opportunity for opportunistic, long-term investors. But you're right to pick your spots.

Here's a compromise. Sample Motley Fool Hidden Gems for free right now. Check out the two top small companies the expert analyst team thinks are best positioned to make you money at your leisure. While you're at it, jot down the stocks they are buying for their real-money portfolio (so far, their picks are crushing the market) -- so you'll have them when you're ready to pull the trigger.

Best of all, there's no risk. If you're not absolutely convinced at any point during the first 30 days, I'll make sure you don't pay a dime. And no matter what you decide, you'll be ready to move when you decide the time is right. If you have less than $1 million to invest, that is. Even Buffett would be proud. To learn more about this special free trial offer, click here.

This article was originally published Feb. 10, 2006. It has been updated.

Paul Elliott owns shares of Pfizer. Intel and Pfizer are Motley Fool Inside Value picks. Motley Fool Options recommended buying calls on Intel. The Fool owns shares of Oracle and has a disclosure policy.