How will you outperform the market this year?
You might think that's a silly question. One year, as a time period (or in this case, the nine months or so left in the year), is too arbitrary to take seriously. Solid investment theses aren't proven over short periods of time.
But while there are certainly no guarantees for how any one strategy will play out over a specific timeframe, you can still put yourself in a better position to beat the market's returns this year by learning two important things.
What usually beats the market
The best type of stock to own over time is small-cap value, as demonstrated by Eugene Fama and Kenneth French's calculations for the 50 years from 1956 to 2005:
Value |
Growth |
|
---|---|---|
Large caps |
13.3% |
9.7% |
Small caps |
17.3% |
8.7% |
Total stock market |
10.5% |
And here's what $10,000 compounds to over that 50 years in each category:
Category |
Final amount |
---|---|
Small-cap value |
$28,919,971 |
Large-cap value |
$5,169,064 |
The total market |
$1,459,430 |
Large-cap growth |
$1,001,164 |
Small-cap growth |
$641,928 |
What makes for small-cap value
Small-cap stocks are easy enough to define. At our Motley Fool Hidden Gems service, we define them as companies with a market capitalization of less than $2 billion. Studies show that the lower the market cap, the higher the rewards to investors. Focusing on companies capitalized at $1 billion or less, or even $500 million or less, will further improve your results.
Defining a value stock is a little trickier. You'll find a lot of differing opinions on what makes a value stock, but here are some traits to look for:
- Low (less than 2.5) price-to-book ratios.
- Low (less than 20) price-to-free-cash-flow ratios.
- Companies with hated products (such as cigarettes).
Why growth lags
Historically, investors have paid too much for growth, and as a group, the fastest-growing companies have failed to match the returns of slower-growing businesses. The most spectacular example might be Dell
Of late, Sirius Satellite Radio
Certainly, there are exceptions. Plenty of individual large-cap growth stocks have produced great results over time. Even those with high price-to-book ratios, dependent on prolonged and significant growth, can achieve market-beating results -- if they have a "franchise value." Think of Microsoft
The Foolish bottom line
While we're aware of these exceptions, at Hidden Gems, we're leading the market's returns by 19 percentage points since 2003 by focusing on the small, hidden, discarded, and ignored values of the world. As phenomenal as the small-cap value historical returns reported above have been, we've managed to improve on them in the four years we've been in service.
We hope you make this the year -- or perhaps the day -- that you adopt the search for small-cap values.
If you'd like some help to start that search, try Hidden Gems, where you'll see our full lineup of picks and additional recommendations for new money now. The recommendations have produced total average returns of 25% since inception, versus 6% for the S&P 500. You can study all of them with a free 30-day guest pass to our service. Regardless of whether you take us up on that offer, we hope you find small-cap value stocks for your portfolio. We think you'll do very well with them -- this year, and in the many years that follow.