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, Wells Fargo (NYSE: WFC  ) and ConocoPhillips (NYSE: COP  ) have drastically different stock prices, but the market value of the two companies is nearly equivalent.

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

 

Recent Share Price

Shares Outstanding

Market Cap

ConocoPhillips

$74.85

1.5 billion

$113.7 billion

Wells Fargo

$34.27

3.3 billion

$113.4 billion

Is Wells Fargo a cheaper company than ConocoPhillips 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 of about 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:

Company

Market Cap

No. of Analysts Following

5-Year Return

Halliburton (NYSE: HAL  )

$30 billion

24

195.6%

Intel (Nasdaq: INTC  )

$105 billion

36

(27.2%)

Walt Disney (NYSE: DIS  )

$61 billion

22

68.4%

Data from Yahoo! Finance.

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

Company

Market Cap

No. of Analysts Following

5-Year Return

Almost Family (Nasdaq: AFAM  )

$334 million

4

996.5%

Olympic Steel (Nasdaq: ZEUS  )

$359 million

6

646.3%

Data from Yahoo! Finance.

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 Almost Family and Olympic Steel, 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 17% average returns per recommendation, versus a loss of 4% 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.

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 in this article. Intel is a Motley Fool Inside Value pick. Disney is a Stock Advisor selection. The Fool has a disclosure policy.


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