When you're trying to pick top stocks, it pays to look beyond the obvious. Sometimes, ideas that make no rational sense turn out to be big winners.
A couple of mutual funds have been using one such winning strategy for more than a decade now, and both have put up stellar returns. And no matter how ridiculous the strategy may seem on its face, it's one you can't ignore if you want to outperform the market.
It's all based on price
The way these two funds -- one from Fidelity, the other from Royce & Associates -- pick stocks sounds like a gimmick. The first thing they look at is a stock's share price. If it's too high, the fund won't touch the shares. If it's below a certain level -- $25 for Royce, $35 for Fidelity -- then the stock passes the first test, and is eligible for the funds to purchase if the managers believe it's a smart investment.
At first, this strategy doesn't seem to make any sense. After all, a company has complete control over its share price. If it wants high-priced shares, it simply chooses to have relatively few shares in its capital structure, such as Google
As it turns out, though, there are some good reasons why a strategy that targets low-priced stocks may do well. Because such companies fly under the radar of Wall Street firms, they may offer more opportunities to discover great investments before anyone else finds out about them. Also, many of those companies are small- or mid-cap stocks, which historically have outperformed their large-cap competitors.
A bear market changes everything, right?
But as many investors found out over the past year and a half, strategies that worked well during bull markets don't always hold up as well when the tables turn. So you might think a strategy that has produced outsized returns might carry a lot of risk -- and cause your portfolio to implode when the market falls.
Yet although shareholders who stuck with these two funds during the bear market haven't escaped unscathed, they don't have much to complain about. Both funds lost about 36% in 2008 -- but that was enough to outperform both the S&P 500 and their respective fund category averages.
Moreover, thus far this year, even though the S&P 500 is roughly unchanged for the year, the two funds are up between 10% and 14%. Royce has ridden stocks such as Intrepid Potash
All told, the funds still have enviable long-term performance numbers despite the big drop since late 2007. Fidelity is up an average of 8.6% annually since 1999, while Royce is up 9.7% -- all in a period during which the S&P 500 actually fell.
Don't dismiss the ridiculous
It's tempting to dismiss even long-term results like these as flukes. Yet the fact that not one but two managers have succeeded in using the same basic strategy to produce the same strong results at least shows that it's more than just a unique occurrence.
The lesson you can learn from this goes beyond simply seeking out low-priced stocks. It's just one example of a much more important concept: By thinking outside the established norm, you may discover opportunities that others would dismiss as being impossible or irrational. In the long run, capitalizing on irrational markets can sometimes provide the most reliable path to riches you'll ever find.
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Fool contributor Dan Caplinger took a long time to realize that even silly strategies can work. He doesn't own shares of the companies discussed in this article. Google is a Motley Fool Rule Breakers recommendation. Coventry Health Care is a Motley Fool Stock Advisor pick. Fossil is a Motley Fool Hidden Gems recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is as serious as we can be.