Hidden Stocks That Can Beat the Pros

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Individual investors often complain that the market favors big investors or that only big-shot professionals get the sweetheart deals. While the pros do have some advantages, individual investors have a ton of advantages of their own. In fact, individual investors like you and me have a huge leg up on the big boys and girls -- we can buy stocks that they could never touch. And that's exactly where you'll find the massive home run stocks.

Hedge funds aren't all they're cracked up to be
Yesterday I read a well-intentioned but one-sided account from a new investment banker who bemoaned the alleged advantages of the uber-wealthy. The author takes aim at one investment vehicle in particular:

Hedge funds. These guys are basically the vehicles of choice for ultra-rich people to get into the financial markets, besides family offices and private wealth managers. What are hedge funds? They are funds that have a 1-5 million deposit minimum, cater to the megarich, and can invest in anything without regulatory restrictions, use leverage to pump up their exposure by 15x, and pretty much eat up a vast majority of the industry's profits.

That's an accurate description of hedge funds. But what the author fails to show is that hedge funds of any size also have to buy highly liquid stocks, the kind that dominate the major indexes such as the S&P 500 (INDEX: ^GSPC) and especially the Dow Jones (INDEX: ^DJI) . Only there can these funds find the liquid stocks they need to execute their strategy, especially if they're using high leverage.

Funds also use high-frequency trading, a controversial method in which they effectively front-run orders and skim a fraction of a cent in profit from each share traded. So their strategy relies on being in and out of millions of shares a day, in addition to high liquidity, in order to make money.

Hedge funds are also advantaged by their scale and inside positioning. The author explains:

Hedge funds have a direct line to investment bank's institutional brokerage teams-these are the guys that spend day and night sucking up to hedge funds, trying to get them the best deals at the cheapest rates. This means that while you're buying stocks and bonds, hedge funds are getting special rights, warrants, sweetheart deals, private placement deals, options, bigger discounts on bonds, and much better bulk commission rates and lower spreads on stocks.

Again, the author accurately portrays the advantages that hedge funds enjoy -- all the power that comes with having a lot of money invested.

But many of these advantages can be neutralized by simply buying quality companies and holding on to them for the long term. Then you don't play the hedges' game of market-timing and losing money on the spread and commissions. This longer time horizon is a huge advantage.

With wealthy investors ever vigilant about returns, hedge funds have to perform quarter after quarter, or they'll quickly lose their investor base. They don't have time to wait around for an undervalued stock to go up. That short-term focus is a boon to investors focused on the long term.

Where to find those huge returns
As I've hinted, the big money has significant disadvantages that can be overcome by two strategies that are very accessible to individual investors:

  • Buy small caps, which tend to be underfollowed.
  • Hold on to good companies for the long term.

The tiny float and low trading volume of many small caps means they're almost inaccessible to hedge funds of any size. And because so few of the big investors are interested in these small fries, the Street provides very little research coverage. In other words, small-cap stocks have a greater chance to be mispriced than their widely followed and heavily traded large-cap brethren. Take a look at some of the companies in the top 1% of the most followed:

Company

Market Cap

Average Daily Volume (Shares)

Analysts

Microsoft (NAS: MSFT) $213 billion56 million30
Apple (NAS: AAPL) $361 billion19 million54
Wal-Mart (NYS: WMT) $202 billion12 million29
Google (NAS: GOOG) $199 billion3 million34

Source: Yahoo! Finance.

With dozens of analysts following each, almost all available information is priced into these stocks. Apple's newest products hits the blogs before they hit the shelves, and Microsoft's problems in mobile are known to everyone. Google's dominance in search is as well known as Wal-Mart's troubled U.S. operations.

In contrast, small caps may have just one or two analysts -- sometimes none -- tracking their business, and that means opportunities for individual investors like us.

Compare those megacaps to Retail Opportunity Investments (NAS: ROIC) , at a slim $471 million market cap. This stock trades just 300,000 shares a day and only one analyst follows it. But CEO Stuart Tanz is using his proven expertise to snap up distressed retail real estate on the cheap. And for you dividend hounds, the stock is a REIT and pays a 4.3% yield.

Secondly, you have to hold on to good small caps and let them grow, and that's something that hedge funds and institutional money often can't do.

With huge market caps and billions in sales already, the blue chips in the table above would have to generate huge additional sales in order to double in size. It's the law of large numbers. In contrast, small caps can grow much more rapidly, but even with big-time winners on their hands, some funds have to sell.

Take the experience of the T. Rowe Price New Horizons Fund, which is focused only on small caps. The mutual fund purchased shares of Wal-Mart during its 1970 IPO and held until 1983, when Wal-Mart outgrew its status as a small cap and the fund was forced to sell one of the best stocks of the century. Today that stake would be worth more than $14 billion -- about what the whole fund is worth now.

Researchers Eugene Fama and Kenneth French discovered that one in eight small-cap stocks becomes large every year, and their research indicates that such companies return on average up to 62% annually. So holding on to quality small caps is the way to generate outsize long-term profits.

As Retail Opportunity Investments continues to scoop up bargains, it will increase cash flow and book value. Eventually the real estate market and the economy will improve, and you'be sitting on a hidden gem that's returning cash to your pocket.

Foolish bottom line
So are you interested in small caps yet? If so, the Fool's chief investment office has identified one small cap poised for long-term profits. Find out which stock in our brand-new free report: "The Motley Fool's Top Stock for 2012." I invite you to take a copy, free for a limited time. Just click here to access the report.

At the time this article was published Jim Royal, Ph.D., owns shares of Microsoft.The Motley Fool owns shares of ROIC, Wal-Mart, Apple, Microsoft, and Google.Motley Fool newsletter serviceshave recommended buying shares of ROIC, Microsoft, Apple, Google, and Wal-Mart.Motley Fool newsletter serviceshave recommended creating a bull call spread position in Apple, a diagonal call position in Wal-Mart, and a bull call spread position in Microsoft. 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.

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