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 eight 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 single strategy will play out over a specific time frame, 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 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 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 to define. At our Motley Fool Hidden Gems service, they are 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. One of the better high-profile examples of this might be Yahoo!, 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 JDS Uniphase (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), Starbucks (Nasdaq: SBUX), and Coca-Cola (NYSE: KO), or click here to read why companies like these have been successful as growth investments when others have failed.

The Foolish bottom line
Although we're aware of these exceptions, at Hidden Gems we're leading the market's returns by more than 23 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.

If you'd like some help to start the search for small-cap values, try Hidden Gems, where you'll see our full lineup of picks and additional recommendations for new money now.

You can 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 -- next 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. Starbucks, Coca-Cola, and Intel are Inside Value selections. TASER is a Rule Breakers pick. Starbucks is also a  Stock Advisor recommendation; the Motley Fool owns shares of Starbucks. The Motley Fool has a disclosure policy.