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 10-and-a-half months or so left in the year, is too arbitrary to take seriously. Solid investment theses aren't proven 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:

Value

Growth

Large caps

13.3%

9.7%

Small caps

17.3%

8.7%

Total stock market

10.5%

 
*Not adjusted for inflation.

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

Small-cap value

$28,919,971

Large-cap value

$5,169,064

The total market

$1,459,430

Large-cap growth

$1,001,164

Small-cap growth

$641,928

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 companies 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:

  • Low (less than 2.5) price-to-book ratios.
  • Low (less than 20) price-to-free cash flow ratios.
  • 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 18% rate over the nine-and-a-half years.

Of late, Overstock.com (Nasdaq: OSTK) and Human Genome Sciences (Nasdaq: HGSI) 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.

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 Adobe (Nasdaq: ADBE), Valero (NYSE: VLO), Stryker (NYSE: SYK), or Blackboard (Nasdaq: BBBB), 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 19 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-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. The recommendations have produced total average returns of 29%, versus 10% for the S&P 500. 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 is a Motley Fool Inside Value and Motley Fool Stock Advisor pick. Blackboard is a Hidden Gems recommendation. The Motley Fool has a disclosure policy.