3 Hidden Gems the Big Boys Can't Touch

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As an individual investor, you have one of the best advantages in the stock market.

Whenever I hear someone talk about how some big-shot investor has a leg up, I remind them that individual investors like you and me have the biggest advantage of all: We're small.

But wait -- why is that an advantage?

Because the best stocks out there -- the ones with the highest potential for gain -- are the ones that only individual investors can buy in quantity.

So below I give you three great small caps to turn into major a profit -- stocks that are much too small for the big boys to touch. I'll also give you a chance to download a free special report with the names of two more "too small to fail" stocks.

The disadvantages of size
Size is a massive disadvantage when it comes to investing.

Superinvestor Warren Buffett has complained about it for years. At a $168 billion market cap, his Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) investment vehicle is just too large. With such a large company, only big acquisitions will meaningfully increase its value. And there are only so many good deals floating around in the large-cap world.

You can see Buffett's fate reflected in Berkshire's $48 billion cash hoard, which he has a hard time deploying into profitable investments. It's even more obvious in Berkshire's declining performance over the last few decades:

Period

Average Annual Increase in Book Value of Berkshire Hathaway

Increase in S&P with Dividends Included

Relative Performance

1965-196918.1%6.4%11.7%
1970s23.3%7.4%15.9%
1980s29.5%18.1%11.4%
1990s25.3%19%6.3%
2000-20098.8%1.2%7.6%

Source: Berkshire Hathaway's 2008 annual letter.

That's a solid performance by any measure, no question about it. But even the Oracle of Omaha can't outperform forever. His relative performance over the last few decades has steadily declined, as you can see by the column on the far right. And Buffett has long said that he could generate 50% annual returns if he had less than a million dollars, meaning that he'd love to buy small caps.

But Berkshire's inability to buy small caps is all the better for us. They're the sector with the greatest potential for outsize returns. As I've noted before, "Finance gurus Eugene Fama and Kenneth French discovered that one in eight small-cap growth stocks becomes large each year. ... These soon-to-be large companies return up to 62% on average annually."

Three value-priced small caps
As I promised at the start of this article, I'm going to detail three small caps that are poised for great returns. They're cheap and underfollowed by Wall Street's big money.

Aeropostale (NYS: ARO)
This retailer of clothing to adolescents and pre-teens has suffered a beat-down lately, as cotton prices have played havoc with its margins. Commodities such as cotton are highly volatile but will ultimately return to more typical levels at some point. Peer lululemon athletica (NAS: LULU) has avoided that crunch by using synthetic fabrics, whose price has remained more stable. In the meantime, shares of Aeropostale are cheap at a market cap of just $825 million, the management team is proven, and the company still has room to grow (such as through its P.S. chain that caters to kids). Management has been aggressively buying stock -- $318 million over the last four quarters.

National Presto (NYS: NPK)
National Presto is the duck-billed platypus of the investment world: a maker of kitchenware, ammunition, and adult diapers. The company's customers are concentrated, but the stock trades for less than 9 times this year's earnings. And the stock has gotten hurt by its association with the defense industry, which is experiencing cutbacks, and pushing the P/Es of well-established players like Northrop Grumman (NYS: NOC) into the single digits. But unlike Northrop, National Presto offers a hidden dividend, as my fellow Fool Anand Chokkavelu explains. While public sites report a yield of 1.1%, National Presto regularly pays a special dividend, which amounted to about 8% at current stock prices.

And now for the cheapest, best stock I see ...

SUPERVALU (NYS: SVU)
This grocery chain's name says it all: it's trading at just 5-6 times this year's earnings -- in other words, it's incredibly cheap. The company is in the middle of an operational turnaround and is working to pay down its heavy slug of debt, but that provides a great opportunity for nimble investors like us. The vast majority of its debt doesn't come due for years, and SUPERVALU's solid profitability allows the business to deleverage, rapidly increasing its book value to shareholders. The company also sees some solid growth opportunities in its Save-a-Lot discount chain, from which it collects high-margin revenue through franchising.

Foolish bottom line
Each of these three stocks is being followed by our Motley Fool Hidden Gems team, which identifies great small caps and then puts real money behind their picks. The Hidden Gems team has also identified two small caps that are too small to fail. If you'd like free access to these two small caps "the government won't let go broke," just click here.

At the time this article was published Jim Royal, Ph.D., owns shares of SUPERVALU, Aeropostale, and Berkshire. The Motley Fool owns shares of Northrop, Lululemon, National Presto, Berkshire Hathaway, SUPERVALU, and Aeropostale.Motley Fool newsletter serviceshave recommended buying shares of Berkshire and Lululemon, as well as buying calls in SUPERVALU. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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