These Stocks Can Always Outperform

David slaying Goliath. The Greeks defeating the Persians. Harry Truman's victory over Thomas Dewey. History is full of stories in which the underdog comes out on top.

But such triumphs aren't just the stuff of tall tales. In fact, a recent New Yorker article by renowned author Malcolm Gladwell concludes that these upsets are much more common than we realize.

As with stocks
The characteristics that, according to Gladwell, help an underdog defeat a "stronger" opponent are identical to those that lead certain stocks to outpace others:

1. They're small.
2. They acknowledge their potential weaknesses.
3. They're unknown, and able to adopt revolutionary strategies that are more effective. Thus, they're able to overtake even the largest competitors.

Gladwell cites scholar Ivan Arreguin-Toft, who calculates that when underdogs possess these qualities, the probability of their emerging victorious skyrockets from just 28.5% to 63.6%.

In effect, the situation completely reverses, and the underdog becomes the odds-on favorite.

These same characteristics also help make winners of small-cap stocks -- which most Wall Street analysts and institutional investors routinely overlook simply because of their small stature.

By way of an example
Let's look at one company that fully embodied those three characteristics when it had its IPO a mere seven years ago:

1. Its initial market capitalization was just $241 million.
2. It was an online company, up against a competitor that had a physical presence with nearly 8,000 U.S. stores and worldwide revenue of more than $5 billion.
3. It was committed to making the experience of renting movies as painless and easy as possible -- with revolutionary ideas like eliminating notorious late fees, letting customers keep movies as long as they wanted, and allowing the "wisdom of the crowds" to recommend movies.

That last clue probably gave it away, but in case you didn't catch it, the company in question is Netflix (NASDAQ:NFLX).

Although its IPO went for $241 million in 2002, this David is now slaying the Goliath that was Blockbuster, and its market cap now sits above $3 billion. And this is just one instance in which the agility that comes with being small has helped a tiny company overtake larger competitors.

Size as strength
So companies that embrace their petite size really have a tremendous, yet often ignored, advantage over their competition.

But how does this apply to our investing? After all, investors like you and me care most about how much money we could make from an investment. We want stocks that can easily double or triple our money -- or more.

And, again, small-cap stocks have the obvious advantage. Think about what it takes for a business to grow 10 times in value:

Data from the World Bank and Capital IQ, a division of Standard & Poor's.

This inherent potential of small caps to double over and over again is the reason they have consistently been the top-performing stocks of the past five years, including 2009.

And the greatest part is that they make the best stocks to own right now, when the market's volatility is high.

That's one reason our Motley Fool Hidden Gems advisors have outperformed the market by a considerable margin since the newsletter's inception six years ago.

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This article was originally published July 21, 2009. It has been updated.

Adam J. Wiederman owns shares of no company mentioned above. Netflix is a Motley Fool Stock Advisor choice, along with Amazon.com. Take-Two Interactive Software is a Motley Fool Rule Breakers recommendation. The Fool's David disclosure policy always slays disclosures on Goliath websites.