Big Winners for Small Investors

Big Winners for Small Investors
By Paul Elliott (TMF Rael)

In 1999, Warren Buffett reportedly made the uncharacteristically bold guarantee that he could earn 50% profits on a portfolio of common stocks each year -- under one condition. Even better, he would accomplish this feat using ordinary, publicly traded stocks that you or I can buy and hold ourselves.

But even though Buffett meets with investors regularly and happily entertains questions from the gallery, he was uncharacteristically hard to pin down on this one point. He left the question open to much speculation, including plenty for years here at Fool HQ.

Enter a group of students from Kansas
While we were lollygagging about the water cooler, debating what exactly was said and when, a college investment class took matters into its own hands. These students trekked across the heartland and requested a private audience with this legend.

And these brave souls stood directly across the table and demanded to know ... Is it true? Did the investing genius really make his much-disputed "50% per year" boast? And more important, does he stand by it today?

Survey says ... Bing! Yes and yes! In fact, not only did this gentleman from Nebraska confirm what many already believed he'd first proclaimed back in 1999, he went one giant step further.

We know all about the gazillions Buffett made on consumer giants like $100 billion Coca-Cola (NYSE: KO). But here's something you may not know. To earn that 50% per year -- to double your portfolio every 20.5 months -- Buffett wouldn't buy Coca-Cola or even his own company, Berkshire Hathaway. He'd buy obscure little outfits with names you've never even heard. How can I be so sure?

Simple. Remember that condition I mentioned earlier? Warren Buffett guaranteed he could earn 50% per year ... if he had less than $1 million to invest. That's because the world's greatest investor would focus on undiscovered, lightly traded small caps -- the area of the market where individual investors have an advantage over the pros.

Why Warren wishes he were you
I know, that sounds crazy. After all, the big money on Wall Street has all the advantages, right? In fact, that couldn't be further from the truth.

Think about it. Pros have way more than $1 million to put to work. They can't mess with smaller stocks -- no matter how undervalued or how great the business. Well, at least they can't without risking running up the price (before their order is filled) or getting stuck with a controlling share of the business.

That's why you see all the trading volume in mega caps. Just take a look at the five most active stocks on the Nasdaq on a recent morning (last Monday, actually).

Company
 Market capitalization
 Shares traded
 
Sirius Satellite Radio (Nasdaq: SIRI)
 $7.4 billion
 28 million
 
Intel (Nasdaq: INTC)
 $125 billion
 26 million
 
Apple (Nasdaq: AAPL)
 $58 billion
 20 million
 
Oracle (Nasdaq: ORCL)
 $62 billion
 19 million
 
Cisco (Nasdaq: CSCO)
 $110 billion
 18 million
 

And the most active stock on the New York Stock Exchange on that same morning? Motorola (NYSE: MOT), with a $52 billion market cap and 18 million shares traded.

So if you've got half a billion to put to work this afternoon, you'd better buy some Intel -- and forget about the next Intel. But let's face it, those monsters don't have many more doubles left in the tank -- much less one every 20 or so months.

Here are a few more numbers to chew on. Ibbotson Associates tracks stock returns by "style" and market cap (size). You could have invested $1,000 in Ibbotson's large-cap universe back in 1927, and you'd have about $2 million today. Not bad.

If you'd bought small-cap value stocks instead, you'd have $33 million. Of course, the word "value" in that last sentence is critical. If you ask me, it's the missing link between the huge profit potential of small caps and the method to the madness of the world's greatest investor.

That's a little trick I learned from Motley Fool co-founder Tom Gardner, back when I worked with him on his Motley Fool Hidden Gems newsletter service. It's why Tom and I both focus on unloved, obscure, and, most important, underpriced companies. That can be a recipe for great volatility, but the returns can be fantastic. But Warren Buffett already told you about that.

Small investors, big promise
If you want to learn exactly how Tom Gardner is beating the market with small-cap value stocks at Motley Fool Hidden Gems, you'll love what comes next.  You can see if it's right for you, without any risk.