The Simple Strategy That Crushes the Market

Many brilliant minds have dedicated decades in pursuit of an investing strategy that can beat the market consistently. I'm guessing the folks at Royce Funds' Low-Priced Stock Fund (RYLPX) spent five minutes. At most.

As you may have guessed, the Low-Priced Stock Fund invests primarily in low-priced small- and micro-cap stocks. For the purposes of this fund, Royce defines a low-priced stock as anything less than $25 per share, although the fund managers typically fish for stocks trading for $10 or less.

That's it. That's their entire strategy. And it works.

That shouldn't work
Savvy investors know that a stock's share price should be irrelevant -- it's the market cap that matters. For example, Research In Motion (Nasdaq: RIMM  ) and Qualcomm (Nasdaq: QCOM  ) have drastically different stock prices, but the market value of the two companies is nearly equivalent.

This is because Qualcomm has about three times as many outstanding shares as the BlackBerry maker (remember, market cap equals price per share times the number of shares outstanding).

Share Price

Shares Outstanding

Market Cap

Research In Motion

$120.78

562 million

$67.96 billion

Qualcomm

$42.15

1,612 million

$67.96 billion

Is Qualcomm a cheaper company than Research In Motion because it has a lower share price? Of course not. Clearly, this strategy should not work.

But it does work -- quite well
Since its inception in 1993, Royce's Low-Priced Stock Fund has posted annual returns just shy of 15% before fees. Over the last decade, the fund has beaten the S&P 500 by nearly nine percentage points.

This isn't a fad. It's not due to luck. This strategy clearly works.

But why?
Simply put, there are fewer eyes focused on this segment of the market, which means there is a greater likelihood that potential bargains will go undiscovered.

Royce states it best in the fund's prospectus:

Institutional investors generally do not make very low-priced equities (those trading at $10 or less per share) an area of their focus, and they may receive only limited broker research coverage. These conditions create opportunities to find securities with what Royce believes are strong financial characteristics trading significantly below its estimate of their current worth.

By sifting for bargains where its competitors refuse to tread, Royce has consistently posted superior returns to both its peers and the S&P 500. Ironically, because no one wants to own low-priced stocks, this security class has become a breeding ground for some of the market's best-performing stocks.

Deja vu all over again
We're intimately familiar with a similar phenomenon at Motley Fool Hidden Gems. As we've written before, most large investors, including Warren Buffett, aren't interested in buying small-cap stocks. This explains why these companies don't attract much attention from Wall Street analysts, which in turn explains why small-cap stocks tend to perform better than large caps and produce more big winners.

Just look at the analyst attention heaped on these large-cap offerings:

Company

Market Cap

No. of Analysts Following

5-Year Return

AT&T (NYSE: T  )

$232 billion

23

97%

Microsoft (Nasdaq: MSFT  )

$290 billion

27

23%

Oracle (Nasdaq: ORCL  )

$113 billion

22

78%

While these small-caps continue to crush the market in relative obscurity:

Company

Market Cap

No. of Analysts Following

5-Year Return

Graham (AMEX: GHM  )

$276 million

1

1,173%

Middleby (Nasdaq: MIDD  )

$1,080 million

4

994%

In contrast to their inexplicable bias against low-priced stocks, Wall Street analysts and institutional investors do have a good reason to ignore small-cap companies. These big boys like to invest in multimillion-dollar chunks, but for companies the size of Middleby and Graham, that's simply not possible without either driving up the stock price or running into SEC reporting problems.

Wall Street's loss is our gain
There you have it: Focus on small, obscure, and ignored companies. Wall Street may not enjoy analyzing small-cap companies, but at Hidden Gems, we've followed that tack and racked up 34% average returns per recommendation, versus 12% for like amounts invested in the S&P.

This isn't a fad. It's not due to luck. This strategy clearly works.

To see all our recommendations, as well as our best bets for new money now, click here for a 30-day free trial. There is no obligation to subscribe.

Rich Greifner also likes low-priced beer. Rich does not own shares of any company mentioned. Middleby is a Hidden Gems recommendation. Microsoft is an Inside Value pick. The Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (47)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 24, 2008, at 7:03 PM, diegorgazzi wrote:

    Well... Yes, small caps have greater potential for growth, however, most small caps will do poorly. You have a greater chance to mess up with a small cap than a blue chip.

  • Report this Comment On April 24, 2008, at 8:23 PM, daleyjf wrote:

    Funny, when I plot RYLPX against the S

  • Report this Comment On April 24, 2008, at 8:24 PM, daleyjf wrote:

    Sorry, last post got truncated. When I plot RYLPX against SP500, it trails in almost every time period.

  • Report this Comment On May 02, 2008, at 3:26 PM, noddypate wrote:

    daleyif,

    That is because RYLPX like most distributes out capital gains and dividends, dropping NAV whose price you are seeing be plotted. I am not sure yahoo's site takes care of dividends from S

  • Report this Comment On June 20, 2008, at 1:51 PM, bluedome wrote:

    One data point does not prove a theory. The results of one mutual fund do not prove that the strategy works unless the fund is equally weighted in every stock that trades under $10, which I doubt. Surely they use some kind of judgment in addition. Therefore, their results most likely have a lot to do with that judgement.

  • Report this Comment On August 29, 2008, at 11:58 AM, Deepfryer wrote:

    Yahoo does indeed account for dividends. So, RYLPX is basically right on par with the S&P, whether you compare them over the last 5 years or the last 10 years. Blah. May as well just invest in SPDRs instead.

    This article actually makes me a little disappointed in Motley Fool. They try to make it sound like this fund is "crushing the market" just because it has slightly outperformed the S&P since 1998. Well, if you go back to 1996 instead, it is exactly even with the S&P. Graph it for yourself against the S&P and tell me if you're impressed. And if you look at RYLPX's results from 2004 until now, it has actually underperformed the market.

    Come on, Motley Fool, I expect better than this. There's no need to mislead your readers with this kind of statistical tomfoolery.

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