How will you outperform the market this year?

You might think that's a silly question. One year, as a time period (or in this case, the nine 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 timeframe, you can still put yourself in a better position to beat the market's returns this year by learning two important things.

What usually beats the market
The best type of stock to own over time is small-cap value, as demonstrated by Eugene Fama and Kenneth French's calculations for the 50 years from 1956 to 2005:

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:

Category

Final amount

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. Focusing on companies capitalized at $1 billion or less, or even $500 million or less, 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 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 might be Dell (Nasdaq: DELL), whose stock priced in more than 20% annual revenue growth for nearly a decade to come, back in 1998. That's right, Dell trades at nearly the same price today as it did in 1998, despite growing sales very profitably at a compounded 19.9% rate over the last eight and a half years.

Of late, Sirius Satellite Radio  (Nasdaq: SIRI) and XM Satellite Radio (Nasdaq: XMSR) are the highest-profile companies to combine lightning-fast sales growth with poor profitability, high price-to-book ratios, and poor returns to shareholders.

Certainly, there are exceptions. Plenty of individual large-cap growth stocks have produced great results over time. Even those with high price-to-book ratios, dependent on prolonged and significant growth, can achieve market-beating results -- if they have a "franchise value." Think of Microsoft (Nasdaq: MSFT) and eBay (Nasdaq: EBAY), or read an explanation of how each of these companies has succeeded as a growth investment where others have failed.

The Foolish bottom line
While we're 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 have been, we've managed to improve on them in the 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 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 25% since inception, versus 6% for the S&P 500. You can study all of them with a free 30-day guest pass to our service. 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 in the many years that follow.

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

Bill Barker does not own shares of any company mentioned in this article. Dell and eBay are Motley Fool Stock Advisor recommendations. Dell and Microsoft are Inside Value picks. The Motley Fool has a disclosure policy.