The Best Investment Wall Street Won't Touch

Small caps offer more opportunities than those stocks covered by Wall Street analysts.

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Motley Fool Staff
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Apr 23, 2010 at 12:00AM
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As an investor, you have a lot of information at your fingertips. In fact, you're probably flooded with data touting the decade's best stock or next year's most influential company.

Whether you're a serious investor or just a beginner, it can be tough to filter out the noise to find the stocks that will truly enhance your financial well-being.

So what should you pay attention to? And what should you ignore?

Stay away from Wall Street
Ignore the analysts. In fact, you can pretty much ignore everyone on Wall Street, for that matter.

Why? They're not very good at serving you.

The Proprietary Research team at Thomson Reuters surveyed analyst recommendations across the S&P 500 index of stocks and came up with some shocking results. Out of the 9,162 recommendations covering these stocks, 93% were bullish. Strange -- I didn't realize the market was so rosy.

At the start of 2008 -- one of the worst years in our market's history -- analysts had a "buy" or "strong buy" rating for nearly 50% of covered equities. Reputable researchers were telling investors to buy Transocean (NYSE: RIG) just before the commodity bust and Wells Fargo (NYSE: WFC) in the middle of the biggest financial crisis in the last 70 years.

Transocean is much better suited as a "buy" today -- it trades for a favorable 9 times earnings, and should benefit from a recovery in offshore and deepwater drilling. Wells Fargo, on the other hand, is still struggling with bad loans and exposure to the real estate industry.

Needless to say, neither of these companies has returned to the share prices they were at when Wall Street suggested them. As The Wall Street Journal so tenderly stated: "Wall Street analysts remain a cheerleading chorus whose published advice is a dubious guide for serious investors."

Why are they so wrong?
Despite those buy and sell ratings, analysts aren't really working for us. They're part of a complicated web of alliances that serve companies and institutions before they serve individuals.

For example, they have relationships with the companies they rate -- and slapping a "sell" rating on one of those companies can often imperil that relationship. In addition, their analysis is primarily serving the company they work for, which has a vested interest in advancing certain stocks for institutional investors.

But here's a little secret: It's a good thing analysts aren't working for you.

The best strategy
The more people following a stock, the less chance you have of finding information that hasn't already been uncovered. And it's the discovery of new information that often changes the price of a stock, as people react to news, to forecasts, or to new data. That's why it's hard to find substantial price discrepancies with huge companies.

Take a look at Verizon and Wal-Mart -- each company has more than 20 analysts covering it! It's really tough to find an undervalued stock when so many individuals are scouring through their financials.

In addition, each company is slated to grow by less than 12% over the next five years. If you're looking for solid dividends, a stable company, and ample growth -- then there's absolutely nothing wrong with Verizon or Wal-Mart. But if you're looking for the next big stock, well, you're looking in the wrong place.

Small-cap stocks are rarely followed by analysts or individual investors, which gives you the ultimate competitive advantage when it comes to unearthing new information. In addition, because they're small, they have room to run, so if you can find a fast-growing company, it may have the chance to be the next home run stock.

But not all small caps are good investments.

What you should look for in a small cap? Membership in a relatively unpopular industry (that way you can ensure not many people are evaluating it), a strong position in its market, a demonstrated ability to increase sales, and a reasonable sale price.

A great place to start
Here's an example of three cheap stocks that have grown their revenues by at least 10% annually over the last three years, have a return on equity north of 12%, and fit all of our "small cap" criteria:

Stock

Market Capitalization

Analyst Recommendations

Price-to-Earnings

3-Year Revenue CAGR*

GigaMedia (Nasdaq: GIGM)

$167 million

0

7.0

52%

STEC (Nasdaq: STEC)

$670 million

2

8.5

18%

Sharps Compliance (Nasdaq: SMED)

$107 million

1

8.1

57%

Advanced Battery Technologies (Nasdaq: ABAT)

$255 million

0

10.9

57%

China Education Alliance (NYSE: CEU)

$171 million

2

9.2

64%

*CAGR = compound annual growth rate.

Not only are these companies that return capital to shareholders, but they're trading on the cheap -- and best of all, they're so small that Wall Street won't bother to touch them. Each company has consistently illustrated top-line growth, so there's every reason to believe they'll keep performing well into the future.

Take STEC for example. This small company manufacturers and designs memory and storage solutions for businesses, and it's been doing so for the last 20 years. According to one analyst, STEC had about 90% market share in the solid-state drive niche in 2009. While competition has certainly increased, the company has two decades of experience to draw upon.

It's not the most exciting story -- but that's the point. The less exciting the story, the better the opportunity, because fewer investors will have the wherewithal to do any due diligence.

These are the types of stocks that the Motley Fool Hidden Gems team looks at and recommends each month. If you're interested in learning more about which small-cap stocks they think have the best chance at crushing the market, take a free, 30-day trial. Just click here for more information. There's no obligation to subscribe.

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This article was originally published March 19, 2010. It has been updated.

Jordan DiPietro doesn't own any shares mentioned above. Wal-Mart Stores is a Motley Fool Inside Value recommendation. The Fool's disclosure policy is written in small caps.