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 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, Wachovia (NYSE:WB) and Dow Chemical (NYSE:DOW) have drastically different stock prices, but the market value of the two companies is nearly equivalent.

This is because Wachovia has over twice as many outstanding shares as the chemical company (remember, market cap equals price per share times the number of shares outstanding).

Is Wachovia a cheaper company than Dow 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 in excess of 14% before fees. Over the past decade, the fund has beaten the S&P 500 by over 10 percentage points annually.

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:

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

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 Deckers and Green Mountain, 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 26% average returns per recommendation, versus 4% for like amounts invested in the S&P.

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

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This article was originally published on April 24, 2008. It has been updated.

Rich Greifner also likes low-priced beer. Rich does not own shares of any company mentioned. Dow and Pfizer are Motley Fool Income Investor picks. Pfizer is also an Inside Value recommendation. The Fool has a disclosure policy.