The Mighty Dow Outdone

Lately, Wall Street commentators have seemed a lot like a high school pep squad cheering the Dow Jones Industrial Average as the large-cap index has marched to multiple record-setting days. And that's all well and good. It's certainly heartwarming to see Dow components such as Honeywell (NYSE:HON) and Hewlett-Packard (NYSE:HPQ) going up instead of down.

But while the Dow's been basking in the spotlight, the small-cap Russell 2000 index has actually outpaced it since Aug. 15.

Small vs. big
These numbers shouldn't be surprising: The Russell 2000 has outpaced the Dow over the past one-, two-, and five-year periods.

So even during a record-setting time period for the blue-chip-laden Dow, small stocks have still outperformed their larger brethren. Why?

One main reason is that small companies have a lot of room to grow compared to their larger, better-established counterparts. That makes sense. Just compare $455 million Buffalo Wild Wings with the largest company in its industry (restaurants), $52 billion McDonald's (NYSE:MCD). To double in size, Buffalo Wild Wings would have to grow by $455 million. McDonald's, on the other hand, would need to grow to more than $100 billion. No easy feat, that.

And while McDonald's certainly could grow, analysts are expecting just 8.6% growth over the next five years. Buffalo Wild Wings, on the other hand, is expected to grow 25% annually. In other words, small caps do better because they have lots of room to grow and can do less in dollar terms to achieve the same percentage gains.

All small caps are not created equal
The Russell 2000's outperformance has been boosted by several strong small companies, but the index contains a slew of losers. Consider:

Again, this is logical -- an index contains a slew of winners and a whole bunch of losers, too. Actually, according to Fama & French research, small-cap growth stocks are historically one of the worst-performing categories of equities.

But small caps in general and the Russell 2000 in particular do well because small-cap value stocks are among the best-performing categories of equities. History has shown that you're better off investing in an underpriced company with strong financials than in an exciting stock promising huge growth in the future in exchange for its lofty stock price.

The bottom line
The next time you see a big to-do about the Dow's record highs, remember that small-cap investing has a huge edge. The key to success is sifting through the thousands of small companies to find the underpriced stocks with strong balance sheets and wide market opportunities.

And they're out there.

Using this approach, the small-cap value approach has led Tom Gardner and his Hidden Gems team to gains of 40%, versus S&P 500 gains of 18%, since 2003. Click here for a free trial to Hidden Gems -- come check out all our picks, research, and commentary, and learn how you can beat the Dow even on its best day.

Fool contributor Glenn Brandys does not own any of the companies mentioned in this article. Openwave Systems is a Rule Breakers recommendation. The Fool has an awesomedisclosure policy.