3 Bargain Stocks for This Market

In "70 Times Better Than the Next Microsoft," my colleague Bill Barker revealed which category of stocks outperformed from 1927 to 2005. Given the insane market volatility we've experienced recently, I've updated Bill's numbers through the end of 2008 to see what critical lessons we can draw:

Source: Kenneth French. Categories are based on market capitalizations and price-to-book multiples.

This data comes from highly respected scholars Fama and French, and it has powerful implications for investors.

It shows that over an 81-year period -- hardly an outlier -- value stocks outperform growth stocks, and small stocks outperform large stocks. The best-performing category was small-cap value stocks, by a wide margin.

How wide?
Those may look like small percentage differences, but with compounding, those small percentages add up to mind-boggling amounts of money. Here's how much $100 invested in 1927 in each of these categories and rebalanced annually would be worth today:

In other words, after 81 years, investing in small-cap value stocks would have yielded anywhere from 7 to 31 times as much money as any of the other categories!

A big reason for small-cap value's dramatic outperformance is Wall Street's constant obsession with large, prominent firms -- like today's Schlumberger (NYSE: SLB) and Halliburton (NYSE: HAL). When hunting for bargains, investors should keep in mind that more prominent stocks such as these are far less likely to be mispriced than somewhat obscure small caps like Dawson Geophysical (Nasdaq: DWSN).

It's no accident, after all, that every one of the market's 10 best-performing stocks of the past decade was a small cap.

And when you combine a group of stocks that tends to be mispriced (small caps) with a group of stocks trading at low valuations (value), you're likely to find some great bargains.

Here's why
When a closely watched company appears cheap, there's often a good reason for it. That's why in a September column, "Don't Touch These 3 Huge Value Traps," I warned investors to stay away from Citigroup, Lehman Brothers, and Wachovia.

Despite the fact that they were trading at or well below book value, these were closely followed institutions dealing with continuing writedowns, managerial missteps, and deteriorating businesses. With so much interest in their condition from Wall Street hot shots -- each had more than 15 analysts following them -- it seemed likely their share price declines were justified.

That may not be the case for small caps. In fact, research cited in The Wall Street Journal, along with my own findings, show that small caps tend to outperform when the market rebounds.

Why? Because small value stocks are less closely followed by professionals, they are more likely to be mispriced. So, when times are tough -- and times have been tough since late 2007 -- that mispricing means that small caps are punished beyond justification.

What to look for today
This isn't to say that small stocks are low-risk. Indeed, if this market has taught us anything, it's that every stock has risk. But the data does indicate that size itself isn't a great measure of safety.

Since this recession began, the small-cap tracking Russell 2000 index has performed basically in line with the S&P 500. And when we examine fallen giants such as Citigroup, Allied Capital (NYSE: ALD), AIG (NYSE: AIG), and the assets formerly known as Lehman Brothers, we see that risk has less to do with whether a company is large or small, and a whole lot more to do with heavy debt levels, shoddy executive compensation structures, unwieldy and arcane business units, or unprofitability.

In light of these facts, investors should consider buying companies with:

• Little or no debt
• Heavy insider ownership
• High profitability

In fact, these are all qualities that Warren Buffett says he looks for. So, taking the lessons from the Fama and French data, and with a debt of gratitude to Buffett, I've selected three small-cap value stocks (each has below-market-average price-to-book value multiples -- Fama and French's value metric) that share those qualities:

Data from Capital IQ, a division of Standard & Poor's. Data through June 3, 2009.

Of course, these three bargain stocks aren't official recommendations, but they share many qualities that make for great investments and are excellent starting points for further research. Moreover, they hail from the small-cap value quadrant, the category that has outperformed all.

Some more ideas
Eighty-one years of historical data confirms that small-cap value stocks tend to outperform over the long haul. Research also shows that if you're going to be looking for great small-cap stocks, now is a particularly great time to begin bargain-hunting.

Our Motley Fool Hidden Gems team looks exclusively at small caps with limited analyst coverage, little or no debt, and dedicated leadership. With stocks so cheap, they're seeing some incredible bargains today. If you're looking for more ideas, click here to read all about our favorite small cap stocks, free for the next 30 days.

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This article was first published May 5, 2009. It has been updated.

Ilan Moscovitz owns shares of Dawson Geophysical, a Hidden Gems recommendation, but has no small kittens. The Fool's disclosure policy is crazy for Pounce!