Suppose I told you that two eminent economists -- guys whose names always seem to get mentioned at Nobel time -- had discovered that one small, often-overlooked corner of the stock universe tended to outperform all of the others over time?

Suppose I also told you that this wasn't some short-term fluke, but something that stayed consistent after crunching almost 80 years of market data -- through the Great Depression, through the early '70s bear market, through the dot-com boom and bust?

And suppose I told you that this research is practically a secret -- while a few professional portfolio managers have put it to good use, many individual investors have never even heard of it? What would you say to that?

Dude, stop with the hype. You're making my head hurt!
And I'd say, "Fair enough. Sometimes I get carried away."

But this research is a big deal, and most individual investors don't know about it. While it's not a complete investment strategy in and of itself, it can add a lot of money to your portfolio over time, and now is a particularly good time to implement it.

The "secret" portfolio supercharger
While they were crunching data for a complex critique of a well-regarded portfolio management formula, economists Eugene Fama and Kenneth French discovered two long-term truths:

  • Small caps outperform large caps.
  • Value outperforms growth.

The first one may seem obvious. After all, unnoticed small caps are more likely to be mispriced and have greater opportunities to exploit.

But the second one doesn't seem as obvious to many academics, who have long maintained that volatility is correlated with returns over time. Value stocks are typically less volatile than growth stocks, so conventional wisdom assumes that you get lower returns for lower "risk." But if you crunch Fama and French's data to calculate average annual returns from 1927 through 2005, you see this:

 

Value

Growth

Large Caps

12.4%

9.5%

Small Caps

15.4%

9.2%

The overall market returned almost exactly 10% a year over that time, meaning that stocks trading at low multiples to their book value (which is how Fama and French defined "value" versus "growth") vastly outperformed the market.

Holy counterintuitive, Batman!

Too much of a big thing ...
And there's another reason why investors should consider adding small caps to their portfolios. See, you're smart to be thinking of adding to your portfolio at present -- after all, it's no secret that valuations across the market are pretty low right now. But consider this: Americans are pouring money into large-cap funds -- $35 billion into the S&P 500 tracking SPDRs in 2008 alone. That's less than ideal, because (1) small caps outperform large caps over the long haul -- particularly in recessions, and (2) if you're like most Americans, you probably have enough large-cap exposure already. SPDRs has more than $77 billion in assets, as compared to the $9 billion held by its small cap peer, the iShares Russell 2000.

Why does that matter? Well, it's important to remain diversified. Observe:

Year

Large Caps

Small Caps

1972-1979

5.1%

19.5%

1980-1989

17.5%

17%

1990-1999

18.2%

16.8%

2000-2008

(3.8%)

3.9%

Source: Ibbotson Associates.

Diversification -- spreading your eggs among many baskets -- remains essential for any long-term portfolio.

And since it's a good idea to look at rounding out our portfolios with small-cap value stocks, I cherry-picked a few good candidates from a Motley Fool CAPS screen:

Stock

CAPS Rating (out of 5)

Price/Book Ratio

Long-Term Debt/Equity

Return on Equity

American Oriental Bioengineering (NYSE:AOB)

*****

1.2

0.3

18%

Highveld Steel & Vanadium (NASDAQ:HSVLY)

*****

1.5

0

40%

IPG Photonics (NASDAQ:IPGP)

*****

1.9

0.1

17%

Lufkin Industries (NASDAQ:LUFK)

*****

1.2

0

21%

Precision Drilling Trust (NYSE:PDS)

*****

0.6

0.9

22%

Rofin-Sinar Technologies (NASDAQ:RSTI)

*****

1.2

0.1

15%

Take-Two Interactive (NASDAQ:TTWO)

****

0.9

0.1

18%

Source: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.

These aren't official recommendations, of course, but check out the key figures here: a price-to-book ratio of less than 2, minimal long-term debt load, and a high level of return on equity. Oh, and a high rating from the Fool's CAPS community -- all but one of those stocks earns five stars, and each was rated by at least 100 members. Stocks that fit all of those requirements almost always merit a closer look -- especially small caps.

These are exactly the kinds of stocks that attract a closer look from our Motley Fool Hidden Gems newsletter analysts. (In fact, two of the stocks named above are Hidden Gems recommendations.) If you'd like to take a look at their best ideas for new money now, help yourself to a free 30-day guest pass.

Fool contributor John Rosevear has no position in the companies mentioned. Precision Drilling is a Motley Fool Global Gains pick. Rofin-Sinar Technologies and American Oriental Bioengineering are Motley Fool Hidden Gems selections. Take-Two and IPG Photonics are Motley Fool Rule Breakers recommendations. The Fool owns shares of IPG Photonics and American Oriental Bioengineering. A first date with the Fool's disclosure policy is way more fun than a weekend away with a model -- especially the Fama and French three-factor model.