70 Times Better Than the Next Microsoft

The ever-helpful moneychimp.com published the following chart comparing historical returns from 1927 to 2005, not adjusted for inflation. (The terms "value" and "growth" are taken from data published by the highly respected Fama and French.)

That's a persuasive case for putting small-cap value stocks to work in your portfolio. (We'll get to just how persuasive later.) And you've probably seen plenty of other data showing that small caps outperform large caps and value outperforms growth.

Why, then, doesn't small growth outperform large growth? And why does small growth, on average, end up being the worst choice for your money?

Moneychimp.com offers a theory, one I think is worth seriously entertaining, at least when it comes to how you invest in small caps. Just think about how investors might mentally categorize large- and small-cap value and growth companies. It might look something like this:

Thanks, Moneychimp. You're on to something.

What do value and growth look like?
What's the price difference between what might be "the next Microsoft" and the unknown and boring? Let's look at the data.

There's never been an official ruling on what separates "value" from "growth." There are dozens of ways to make those distinctions, and the data that Fama and French produce comes from their own method of sorting out what makes a value stock and what makes a growth stock. Let's look at a more accessible listing of stocks to give you an idea of what value and growth look like according to recent data. We'll take two of the holdings from each of the Vanguard small- and large-cap value and growth index funds:

These companies aren't selected to imply that any one or two are likely to do better than others over time. Instead, they're intended to show you what some of the larger players look like when you compare their price to both their book value and their earnings. Obviously, to justify their prices, companies categorized as "growth" need to grow their earnings much faster than the companies in the value quadrants.

The numbers attached to these small-cap growth companies are particularly startling. That's not to say that Intuitive Surgical and Pharmaceutical Product Development are necessarily overpriced, nor that they won't grow their earnings sufficiently to be good investments from here. But to the extent that they represent the expectations built into their brethren in the small-cap growth field, we can see why the returns for the quadrant as a whole end up disappointing investors.

Taken as a whole -- as measured by thousands of companies, not just two -- small-cap stocks will be more inaccurately priced than large caps in the market, but not necessarily better-priced. The inaccuracies work both ways. Those that are historically overpriced (small-cap growth) tend to be more overpriced than their large-cap brethren, and those that are underpriced (small-cap value) can be more so than their large-cap cousins. At the moment, however, they aren't as a group more underpriced than those cousins as measured by the price-to-earnings ratio, although they still look cheaper on a price-to-book metric.

What's the cost?
The rewards of being aligned with the right quadrant instead of the wrong one over 78 years are absolutely staggering. Compounded over those 78 years, $100 would translate to:

Is 78 years a relevant investment period? Well ... kind of. It's just slightly longer than an average American life span. So the difference between small-cap value and small-cap growth over a lifetime has been a multiple of more than 70 times the end result. That's right: 70 times. (So get started investing early, and start your kids' accounts now!)

There are literally thousands of companies in that small-cap value quadrant that you should be concentrating on, none of which can possibly be described as "the next Microsoft." They might not carry the wallop of a potential Microsoft over the short term, but over many decades, and taken as a group ... wow.

We spend every day looking for the next not-exactly-Microsoft at Motley Fool Hidden Gems. We closely follow a manufacturer of clothing labels and a producer of components for manufactured homes (both are market-beaters). But you don't have to be an expert at finding the best ones in that quadrant, because the average returns have just been so monumental.

Remember that the next time you hear that somebody has found the next Microsoft.

Hidden Gems actually does have a terrific record of finding the better-performing companies in the small-cap arena. Take a free one-month guest pass to help you find small-cap winners. There's absolutely no obligation.

This article was originally published on Jan. 12, 2006. It has been updated.

Bill Barker does not own shares of any company mentioned. Microsoft is an Inside Value recommendation. Bank of America is an Income Investor selection. Intuitive Surgical is a Rule Breakers pick. The Fool has a disclosure policy.