With the S&P 500 still down some 20% since its 2007 high, some folks are wondering whether it's time to take advantage of the bargains still in the market.

So the urgent question is: Does buying beaten-down stocks actually lead to riches?

The shocking truth 
To evaluate the merits of a contrarian approach to the market today, I recently ran a screen to discover how well a similar tactic would have worked during the previous recession. I divided all 278 large-cap stocks into five groups by performance over that period and looked at how well they did over the following five years.

Here's what I found:

Quintile

Performance,
 March-November 2001

Annualized Performance,
November 2001-November 2006

1

 (51.3%)

6.1%

2

 (25.1%)

6.5%

3

 (13.4%)

9.1%

4

 (3.6%)

3.9%

5

 9.6%

9.2%

Total

 (16.9%)

7.1%

Source: Capital IQ, a division of Standard & Poor's.
Stocks trading on major U.S. exchanges capitalized at more than $10 billion on March 1, 2001.

As you can see, stocks that had been scorched the most over that blistering eight-month period actually underperformed those that had done just fine -- by 3.1 percentage points annually!

How'd that happen? 
Over those painful eight months, the market had correctly anticipated the value of many of these large companies and discounted them accordingly. A 50% haircut is certainly a markdown -- but it's not necessarily a sale, especially if the value of the company has been cut in half or was overvalued to begin with.

The savviest investors know that willy nilly "contrarianism" isn't a sure path to riches. As the financial disasters of the past few years illustrate, companies often get punished for all the right reasons. And in those cases, their plight can be as bad as you think -- and worse.

The envelope, please 
Here are the names of five huge companies that are likely to be value traps. All five have had massive declines, which make shares appear tempting to investors. However, they are also:

  • Heavily scrutinized large companies.
  • Among quintiles whose performance was anemic in the latest recessionary go-round.
  • Employing considerable leverage.
  • Sporting low or moderate ratings by our Motley Fool CAPS community.

Company

Prerecession Market Capitalization
(in billions)

Return Since Beginning of Recession

Analyst Coverage

Sprint (NYSE: S)

$44.1

(76%)

31

AIG (NYSE: AIG)

$147.4

(96%)

7

Alcatel-Lucent (NYSE: ALU)

$18.5

(61%)

32

Weyerhaeuser (NYSE: WY)

$15.4

(41%)

17

American Express (NYSE: AXP)

$68.9

(30%)

20

Sources: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.
According to the National Bureau of Economic Research, the recession began Dec. 1, 2007.

Yes, shares of these companies have fallen dramatically, but only because they've dealt with massive deleveraging, deteriorating business lines, awful competitive dynamics, and/or managerial missteps in the face of an already ugly economic period.

Given the amount of attention these massive companies generate on Wall Street (as seen in that third column, "Analyst Coverage"), there's a strong chance that the sell-off was justified. If history is to repeat itself, thrashed large caps are not going to be the best stocks to buy now. If you want to profit from the recent marketwide sell-off, you need to look where others aren't.

A contrarian contrarian strategy
This time I compared the post-recession returns of the aforementioned 278 large caps to the performance of 1,740 smaller companies. I had expected some disparity in their five-year returns, but its sheer size was astounding:

Quintile

Small-Cap Performance, March 2001-Nov. 2001

Small-Cap Annualized Performance, Nov. 2001-Nov. 2006

Large-Cap Performance, March 2001-Nov. 2001

Large-Cap Annualized Performance, Nov. 2001-Nov. 2006

1

(53.8%)

23.7%

 (51.3%)

6.1%

2

(19.8%)

16%

 (25.1%)

6.5%

3

(1.4%)

14.5%

 (13.4%)

9.1%

4

14.7%

14.3%

 (3.6%)

3.9%

5

57.3%

13.7%

 9.6%

9.2%

Total

(0.7%)

16.7%

 (16.9%)

7.1%

Source: Capital IQ, a division of Standard & Poor's. Companies capitalized between $100 million and $2 billion versus those capitalized at more than $10 billion on March 1, 2001.

A small-cap contrarian approach following the last recession would have paid off handsomely, turning a $10,000 investment into nearly $30,000 in just five years. But not only did the most beaten-down small caps outperform their spared peers, every quintile of small caps outperformed every quintile of large caps over the following five years.

In fact, every single one of the top 10 stocks since the last recession was a small or mid cap.

Not only have recent years have been an exceptionally great time to own small caps, a number of studies have shown that over the long haul, small caps outperform larger companies. According to research from professors Fama and French, small-cap value stocks outperformed their larger counterparts 17.3% to 13.3% on average from 1956 to 2005.

That's because small caps tend to be less closely watched by big brokerage houses and the financial media, so their stock prices are more likely to behave irrationally -- and provide huge opportunities during times of turmoil.

Small is good
In other words, if you want to take full advantage of all the wonderful values in the market today, you need to look into small-cap stocks.

If you're looking for small cap stock ideas, enter your email address in the box below to get "Motley Fool Top Picks & Perspectives 2011," a new free report with stock recommendations and portfolio guidance for the year ahead. We'll also tell you more about Million Dollar Portfolio, our real-money portfolio service that buys the best of our investing ideas, opening for the last time this year. To get started, just enter your email address in the box below.

Ilan Moscovitz doesn't own shares of anything mentioned here. American Express is a Motley Fool Inside Value recommendation. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.