How are you going to outperform the market this year?

You might consider that a somewhat silly question. The time period of one year, or in this case the seven months or so left in the year, is too arbitrary to take seriously. Solid investment theses aren't proved out over short periods of time.

But while there are certainly no guarantees for how any one strategy will play out over a specific time frame, that doesn't mean you can't put yourself in a better position to beat the market's returns this year by learning a couple of things.

What usually beats the market
The best type of stock to have owned over time is small-cap value. Here are the results for the 50 years from 1956 to 2005, as calculated by Eugene Fama and Kenneth French:



Large caps



Small caps



Total Stock Market


*Not adjusted for inflation.

And here's what $10,000 compounds to over that 50 years in each category:

Small-cap value:


Large-cap value:


The total market:


Large-cap growth:


Small-cap growth:


What makes for small-cap value
Small-cap stocks are easy enough to define. At our Motley Fool Hidden Gems service, we define it as any company with a market capitalization of less than $2 billion. Studies show that the lower the market cap, the higher the rewards to investors, so targeting your search to companies capitalized at $1 billion or less or even to $500 million will improve your results further.

Defining a value stock is a little trickier. You'll find a lot of differing opinions on what makes a stock a value stock, but here are some traits to look for:

  1. Low (less than 2.5) price-to-book ratios.
  2. Low (less than 20) price-to-free cash flow ratios.
  3. Companies with hated products (such as cigarettes).

Why growth lags
Historically, investors have paid too much for growth, and as a group, the fastest-growing companies have failed to match the returns of slower-growing businesses. One of the better high-profile examples of this might be Yahoo! (NASDAQ:YHOO), whose stock priced in enormous annual revenue growth for nearly a decade ahead back in 1999. That's right, Yahoo! trades at the same price today as it did in 1999, despite growing sales very profitably at a compounded 35% rate over the past seven years.

Of late, TASER (NASDAQ:TASR) and JDSU (NASDAQ:JDSU) are examples of high-profile companies that have combined lightning-fast sales growth with poor profitability, high price-to-book ratios, and poor returns to shareholders.

To be sure, there are exceptions. Plenty of individual large-cap growth stocks have produced great results over time. Even those with high price-to-book ratios that are dependent on prolonged and significant growth can achieve market-beating results -- if they have what is referred to as a "franchise value." Think of McDonald's (NYSE:MCD), Intel (NASDAQ:INTC), and Coca-Cola (NYSE:KO), or click here to read an explanation of how companies like these have been successful as growth investments where others have failed.

The Foolish bottom line
Though we're aware of these exceptions, at Hidden Gems we're leading the market's returns by more than 35 percentage points since 2003 by focusing on the small, hidden, discarded, and ignored values of the world. As phenomenal as the small-cap value historical returns reported above are, we've managed to improve on them over the past three-and-a-half years we've been in service.

We hope you make this the year -- or perhaps the day -- that you adopt the search for small-cap values.

If you'd like some help to start off that search, try Hidden Gems, where you'll see our full lineup of picks and additional recommendations for new money now. You can take a look at all of them with a free 30-day guest pass to our service. But regardless of whether you take us up on that offer, we hope you find small-cap value stocks for your portfolio. We think you'll do very well with them -- this year, and the many years that follow.

This article was first published on March 22, 2007. It has been updated.

Bill Barker does not own shares of any company mentioned in this article. Yahoo! is a Motley Fool Stock Advisor recommendation. TASER is a Rule Breakers pick. Intel and Coca-Cola are Inside Value selections. The Motley Fool has a disclosure policy.