"Valuations are starting to get silly."

So said the chief investment officer at a major commercial bank during a recent call on the state of the economy. With the S&P 500 down 38% in 2008 and down an additional 24% year to date, shares of even stable blue chips cratering, and investors scared witless, others are wondering whether it's time to take advantage of some great bargains.

So the urgent question is: Does buying beaten-down stocks actually lead to riches?

The shocking truth
To evaluate the merits of a contrarian approach to the market today, I recently ran a screen to discover how well a similar tactic would have worked during the last recession. I divided all 278 large-cap stocks into quintiles by performance over that period and looked at how well they did over the following five years.

Here's what I found:

Quintile

Performance, March-November 2001

Annualized Performance, November 2001-November 2006

1

 (51.3%)

6.1%

2

 (25.1%)

6.5%

3

 (13.4%)

9.1%

4

 (3.6%)

3.9%

5

 9.6%

9.2%

Total

 (16.9%)

7.1%

Stocks trading on major U.S. exchanges capitalized at more than $10 billion on March 1, 2001.
Data courtesy of Capital IQ, a division of Standard & Poor's.

As you can see, stocks that had been scorched the most over that blistering eight-month period actually underperformed those that had done just fine -- by 3.1 percentage points annually!

How'd that happen?
Over those painful eight months, the market had correctly anticipated the value of many of these large companies and discounted them accordingly. A 50% haircut is certainly a markdown -- but not necessarily a sale, if the value of the company has been cut in half or was overvalued to begin with.

The savviest investors know that willy-nilly contrarianism isn't a sure path to riches. As financial disasters WaMu, E*Trade (NASDAQ:ETFC), and MBIA (NYSE:MBI) illustrate, companies often get punished for all the right reasons. And in those cases, their plight can be as bad as you think -- and worse.

The envelope, please
Here are the names of three huge companies (market caps around $10 billion or more a year ago) that are very likely to be value traps. All three have had massive declines in the past year, which make shares appear tempting to investors. However, they are also:

  • Heavily scrutinized large caps.
  • Returning among quintiles whose performance was anemic in the last recessionary go-around.
  • Rated with one or two stars (the lowest ratings possible) in our Motley Fool CAPS community.

Since we began tracking the collective intelligence of our CAPS investment community in November 2006, one- and two-star companies have fared poorly, with an average annualized loss of 11.4% and 5%, respectively.

Company

Pre-Recession Market Capitalization
(in billions)

Analyst Coverage

Recession Return

Capital One Financial (NYSE:COF)

$19.9

22

(83%)

Citigroup

$166.3

14

(97%)

HSBC (NYSE:HBC)

$101.1

15

(68%)

Data from Motley Fool CAPS, Yahoo! Finance, and Capital IQ, a division of Standard & Poor's.
According to the National Bureau of Economic Research, the present recession began Dec. 1, 2007.

Yes, shares of these companies have fallen dramatically, but that's because they've dealt with massive writedowns, deteriorating business units, managerial missteps, and/or CEO firings in the face of an already ugly economic period.

Given the amount of attention these massive companies generate on Wall Street (as seen in that third column, "Analyst Coverage"), there's a strong chance that the sell-off was justified. If history is to repeat itself, thrashed large caps won't be the best stocks to buy now. If you want to profit from the recent marketwide sell-off, you need to look where others aren't looking.

A contrarian contrarian strategy
This time, I compared the post-recession returns of the aforementioned 278 large caps to the performance of all 1,740 small caps. I had expected some disparity in their five-year returns, but the sheer size was astounding:

Quintile

Small-Cap Performance, March-November 2001

Small-Cap Annualized Performance, November 2001-November 2006

Large-Cap Performance, March-November 2001

Large-Cap Annualized Performance, November 2001-November 2006

1

(53.8%)

23.7%

 (51.3%)

6.1%

2

(19.8%)

16.0%

 (25.1%)

6.5%

3

(1.4%)

14.5%

 (13.4%)

9.1%

4

14.7%

14.3%

 (3.6%)

3.9%

5

57.3%

13.7%

 9.6%

9.2%

Total

(0.7%)

16.7%

 (16.9%)

7.1%

Companies capitalized between $100 million and $2 billion versus those capitalized at more than $10 billion on March 1, 2001.
Data courtesy of Capital IQ, a division of Standard & Poor's.

A small-cap contrarian approach following the last recession would have paid off handsomely, turning a $10,000 investment into nearly $30,000 in just five years. Not only did the most beaten-down small caps outperform their spared peers, but also, every quintile of small caps outperformed every quintile of large caps over the following five years.

And that last recession was no anomaly. According to T. Rowe Price, small caps have beaten large caps by nine percentage points on average over each of the past 10 recessions.

Among the most disappointing contrarian plays would have been buying $59 billion Nortel Networks (NASDAQ:NT) back in November 2001, when it was "on sale" for nearly 70% off, because it's been falling ever since. $274 million Titanium Metals (NYSE:TIE), which had fallen by a similar amount, went on to become a 37-bagger.

In fact, every single one of the top 10 stocks since the last recession was a small or mid cap. The very largest among them was an unappreciated $6 billion computer hardware maker destined for greatness named Apple (NASDAQ:AAPL).

Studies have shown that over the long haul, small caps outperform larger companies. According to research from professors Fama and French, small-cap value stocks outperformed their larger counterparts 17.3% to 13.3% on average from 1956 to 2005.

That's because small caps tend to be less closely watched by big brokerage houses and the financial media, so their stock prices are more likely to behave irrationally -- and provide huge opportunities during times of turmoil.

In other words, if you want to take full advantage of all the wonderful values in the market today, you need to look into small-cap stocks.

Small is good
At Motley Fool Hidden Gems, we look exclusively at companies capitalized at less than $2 billion, with little or no analyst coverage, that are led by dedicated managers/founders, and that have a wide market opportunity. It's here that you are going to find the companies that truly are undervalued.

So far, that strategy has paid off. Since inception in 2003, Hidden Gems picks are outperforming the S&P 500 by five percentage points on average.

To see our newest recommendations and top picks for new money now, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

This article was originally published Aug. 7, 2008. It has been updated.

Ilan Moscovitz owns shares of Apple. Apple and Titanium Metals are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.