How will you outperform the market next year?

You might consider that a somewhat silly question, since a one-year time frame 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 for the rest of this year or next. You just need to learn 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 them as any companies with a market capitalization of less than $2 billion. Studies show that the lower the market cap, the higher the rewards to investors. Targeting your search to companies capitalized at $1 billion or less, or even to $500 million, will further improve your results.

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. The most spectacular example of this might be Dell, whose stock priced in more than 20% annual revenue growth for nearly a decade ahead back in 1998. That's right, Dell trades at the same price today it did in 1998, despite growing sales very profitably at a compounded 19.9% rate over the past nine years.

Of late, Whole Foods Market (NASDAQ:WFMI) and JetBlue Airways (NASDAQ:JBLU) are among the higher-profile companies that have combined lightning-fast sales growth with poor profitability, high price-to-book ratios, and recent 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 PepsiCo (NYSE:PEP), Altria (NYSE:MO), Hershey (NYSE:HSY), and Paychex (NASDAQ:PAYX), or click here to read an explanation of how such companies as these have been successful as growth investments where others have failed.

The Foolish bottom line
But while aware of these exceptions, at Hidden Gems, we're leading the market's returns by more than 32 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 four 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. In the past 19 months, the new recommendations have performed better than the S&P 500 -- and the older recommendations really demonstrate how well small-cap value stocks have performed. 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. Dell, Whole Foods, and JetBlue are Motley Fool Stock Advisor recommendations. Dell is an Inside Value pick. The Motley Fool has a disclosure policy.