Now's the Time to Invest in These Stocks

Individual investors: The coast is clear. It's time to invest in small caps again.

Yes, small-cap stocks have indeed rebounded along with the rest of the market since the March lows of last year, and you still need to be selective, but as a result of three major changes in the market, individual investors like you and me once again have a tremendous opportunity to find great values in the small-cap market.

Why this matters to you
Small-cap stocks, bought prudently and patiently, can be an individual investor's best friend.

Why? For one, institutional investors (mutual funds, pensions, endowments, etc.), which manage billions in assets, have a difficult time buying meaningful stakes in small companies without consequently buying controlling stakes in the company. Remember, large-fund managers are more interested in making money from their investments than running dozens of tiny businesses, so they are forced to invest in larger companies that can absorb their sizable investment amounts.

Warren Buffett has lamented that he could earn 50% annualized returns if he had less than $1 million to invest, but with the massive Berkshire Hathaway portfolio, he's forced to focus on the Johnson & Johnsons (NYSE: JNJ) and American Expresses (NYSE: AXP) of the world. In fact, not even 1% of the Berkshire portfolio is dedicated to small- and microcap companies. They're simply too small for him to buy.

Second, precisely because the big fish reside in the large-cap ocean, that's where most of the analysts reside, too, and that presents an information gap that the astute individual investor can exploit. As former Wall Street analyst Stephen T. McClellan noted in his book Full of Bull, "Most analysts at major firms get attention and make their reputations by emphasizing big cap recommendations.

Small stocks present the individual investor with a better prospect of undiscovered value and the potential to achieve greater prominence in the future as their market caps expand."

Individual investors stand little chance of finding multibaggers among these large stocks with so much analyst coverage:

Data provided by Yahoo! Finance, as of March 4.

Without a doubt, the individual investor can profit from these stocks, but it's unlikely that we'll find an information edge over the Wall Street wingtip crowd on a stock like Visa.

And that's OK. We just need to play to our strengths as individual investors. Thanks to the three changes in the market, now's the time to take advantage of our opportunity.

Carpe diem
So what are the three major changes?

1. The disappearance of hedge funds. During the Roaring Mid-'00s, upstart hedge funds, which were battling one another tooth and nail for outperformance to attract more assets, flocked to the small-cap market in hope of profiting from the inherent market inefficiencies. In fact, at the height of the market, one survey found that hedge fund holdings of some small-cap stocks grew by 40% year over year. Since the credit crisis began in 2008, however, about 2,100 hedge funds have gone under, and they've taken their interest in small stocks with them.

2. The emergence of "high-frequency" traders. As the hedge funds fell apart in 2008, high-frequency traders picked up the slack. Armed with supercomputers and complex algorithms, high-frequency traders hunt for the slightest "signals" or inefficiencies in the market and process trades in microseconds. Given the relative illiquidity of the small-cap markets, these high-frequency programs need to focus on larger, more frequently traded companies.

3. Shrinking Wall Street research budgets. According to Capital Institutional Services, commissions at investment banks (which fund research) are expected to drop 20% to 40% year over year. This led to reduced research budgets, a decline in analyst staffing levels, and coverage of fewer stocks.

Wall Street's reduced coverage of small caps is overall good news for us as individual investors, but it will force us to be more patient with our investments and hold them longer, because it may take time for the big money to catch on to a big winner.

3 ideas to get you started
Don't worry. I'm not going to leave you without providing specific stock ideas to help you profit from these three changes. They are:

1. Almost Family: A $320 million company that provides visiting-nurse and personal-care services. In 2008, 92.2% of its revenue came from Medicare, Medicaid, or another government program, so it's already well-versed in a government-payer system. Analysts covering: Eight.

2. FormFactor: An $830 million technology company that develops systems to test semiconductor chips and wafers and generates just 34% of its revenue in North America. The company's customers are set to introduce new designs this year, which could boost sales. Analysts covering: Eight.

3. Female Health: With just $170 million in market value, it's the designer and manufacturer of the only FDA-approved female condom. In 2009, Female Health made more than 90% of its sales outside of the U.S., and CEO O.B. Parrish has been at the helm since 1994. In recent years, it has benefited from increased HIV/AIDS spending, particularly in developing areas in Africa and South America. As my Foolish colleague Tim Hanson recently noted, this stock is definitely worth further research. Analysts covering: Zero.

Foolish bottom line
Small-cap stocks present individual investors with an opportunity to invest in great companies before the rest of the market catches on. Today, with institutional investors increasingly focused on large-cap behemoths, now's the time to invest in small caps.

If you'd like more small-cap ideas, take a 30-day free trial of our Motley Fool Hidden Gems service. Click here to get started. There's no obligation to subscribe.

This article was originally published Dec. 3, 2009. It has been updated.

Fool analyst Todd Wenning likes his sugar with coffee and cream. He owns shares of Johnson & Johnson, a Motley Fool Income Investor pick. FormFactor is a Motley Fool Hidden Gems selection. Berkshire Hathaway is both an Inside Value and Stock Advisor recommendation. Motley Fool Options has recommended long calls on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway, Almost Family, and FormFactor, and has a disclosure policy.