Too Good to Be True

Based on historical returns, small caps -- particularly those in the "value" camp -- have provided superior returns to investors over time. That's the message of this chart from moneychimp.com (a helpful investing website with a treasure trove of information for those who like to play around with numbers):

Small-cap value may be superior, but is it supreme?
If small caps are good, and value is good, then microcaps and deeper value should be better, right? I noticed recently that moneychimp has added some new data to test this hypothesis.

The iShares Russell Microcap Index (IWC) defines microcaps as companies with a market capitalization between $50 million and $550 million. Moneychimp defines "deep value" as "the cheapest third or so ... of the parent index." "Cheap," as used in this database, is defined by a number of proprietary metrics, including but not limited to price-to-book, price-to-sales, and price-to-earnings ratios.

What does the data show?

Whoa.

If you compound the results of 17.3% returns over time -- for not even that much time -- you start coming up with some truly startling numbers. You'll more than double your money in five years, have 24 times your stake in 20 years, and over that entire 79-year period, you'll turn a mere $10 into nearly $3 million. That last example is absurd, sure, but do numbers like this demand that you consider increasing your exposure deep-value micro caps?

Historical context
Well, maybe. Jeremy Siegel, in his book The Future for Investors, lists the top returns from the surviving members the original 1957 S&P 500 through 2003 (dividends reinvested). Here's how they did:.

During the same 1957 to 2003 period, microcap deep value produced returns of 18.66%.

Don't learn the wrong lessons
Returning to the question posited above, if those numbers are accurate, there isn't a reason to waste your time with any "growth" stocks or with any stocks larger than $550 million (not named Altria), assuming you have three things:

1. A time machine.
2. Complete immunity from capital gains taxes.
3. The ability to make unlimited trades without paying commissions or having spreads eat into your returns.

Of those three, the time machine may well be the easiest to obtain.

That's because the collected data assumes that you can track thousands of small-cap or microcap stocks, separate them into "value" and "growth," and costlesslyrebalance them. Obviously, that's not a realistic method for the individual investor. Aside from the tax costs incurred by attempting this type of investing in any taxable account, the commissions would be horrendous, putting a dent in any theoretical outperformance of the market.

In other words, those 17.3% annual returns are too good to be true.

A better way
But let's not throw the baby out with the bathwater. Finding the right small-cap value stocks is worth the effort. Over time, value does defeat growth, and small caps do outperform large caps. While constant rebalancing within a theoretical framework enhances the outperformance, such rebalancing isn't necessary to improve your results. Buying to hold in a small-cap value framework will still get you better returns.

So consider skewing your investments toward small-cap value. You should do better over your investing life -- even if those returns don't approach 17% per year.

And if you'd like some help learning to find great small-cap companies at the right valuation, consider joining us Motley Fool Hidden Gems. While we concentrate mostly on small caps, we also offer monthly coverage on promising micros. The average returns for our recommended stocks are 24%, vs. 10% for like amounts invested in the S&P 500. You can access the entire Hidden Gems service for free with a 30-day trial.

Bill Barker does not own shares of any companies mentioned in this article. Pfizer and Coca-Cola are Inside Value picks. Merck is an Income Investor pick. The Fool has a disclosure policy.