— Peter Lynch

When looking for stocks that can score huge price gains in the future, it often is helpful to look back and see what worked in the past.  Just for kicks, I performed a stock screen for the ten stocks in the Russell 3000 Index (Chicago Options: ^RUA) with the greatest total return over the past 10 years.  The numbers are awe-inspiring:

Best Performing Stocks of the Past Decade

Source: Bloomberg

Looking at the list, the stocks come from a wide range of industries, yet almost all have one thing in common: they started their epic run as “small-cap” companies (i.e., below $1 billion market capitalization). Some, like Monster Beverage (formerly Hansen Natural), started very small.

Editor’s note: Uncover 3 of our favorite growth stocks by checking out our Top Growth Stocks to Own Now report. 

Intuitively, this makes sense based on the law of large numbers.  It’s much easier to grow 50%-100% per year when starting from a small base than it is when starting from a large base. Investing in the next Wal-Mart Stores (NYSE: WMT) is not going to happen by investing in Wal-Mart itself. Otherwise, large-cap companies with $100 billion-plus market caps would quickly grow larger than the economy itself!

The Magic Formula

As I demonstrated in So, You Want to Be a Value Investor?, small-cap value stocks have dramatically outperformed all other types of stocks over the long-term:

Small-Cap Value is #1

Source: Ibbotson Associates

But did you also notice in the above table that small-cap growth stocks did not outperform large-cap value stocks?  One must conclude that company size by itself is not sufficient to pick the best long-term winners. Rather, a combination of small size and value (e.g., low price-to-earnings) appears to be the magic formula.

It is not a coincidence that Monster Beverage, the best performing stock of the past decade, not only had a tiny market cap in 2002 but also was cheap with a P/E ratio of only 10. The P/E ratios of other small stocks in the top ten were similarly low – Cal-Maine Foods had a P/E of 9 and Deckers Outdoor had a P/E of only 7.  While the investing crowd at the turn of the century was chasing Internet stocks trading at P/E ratios of 100 and up, the real future winners were these non-tech and cheap little guys that nobody was paying attention to.

Three Risk Factors is Better Than One

In fact, the magic formula of small size and value is at the heart of the Fama-French Three-Factor Model (TFM), which has replaced the single-factor capital asset pricing model (CAPM) as the accepted standard for predicting the risk and expected return of a stock. Long story short, the CAPM assumed that a stock’s risk was completely explained by its relative volatility compared to the general stock market (a.k.a. beta).  In contrast, the TFM adds small size and value metrics as additional risk factors. Academic research has confirmed that the TFM predicts 95% of a stock portfolio’s subsequent return compared to the CAPM’s paltry 70% predictive power. 

Historically, small stocks had been thought to offer higher returns because they were more volatile (i.e., had higher betas than the market):

 Small Caps Are More Volatile

Source: Ibbotson Associates

What TFM found is that small-cap stocks generated a higher return even after adjusting for their higher beta. There is something driving small-stock outperformance other than higher volatility. What is that “something else?”

Does Small = Riskier?

Without question, being of small size and selling for a value price increase returns, but there is considerable debate whether these increased returns are based on increased risk – the efficient market theorists’ position – or are simply the result of market inefficiency. University of Chicago finance professor Eugene Fama, an author of the TFM, is clearly in the increased risk camp. With regard to small stocks, he states:

The 1980s were, supposedly, the longest period of continuous growth the country had seen since the Second World War. Yet, in that decade, small stocks were in a depression. Small stock earnings never recovered from the ’80-’81 recession. They were low the whole decade. Why did that happen in the ’80s? I don’t know. But it happened. And it tells you there is something about small stocks that makes them more risky.

Similarly, Nobel laureate William Sharpe believes “small and downtrodden companies are more likely to fail in a serious depression than are large and profitable companies” and GMO investment strategist Jeremy Grantham writes:

Value investing has always had a hidden but serious risk — the 60-year flood. The so-called price/book effect (and the small stock effect) sound like a free lunch, but, in 1929-33, 20% of all companies went bankrupt. They were not the large high quality blue chips but small “cheap stocks” with low price-book ratios.

In contrast, Joel Greenblatt of Gotham Capital in his funny-sounding book “You Can Be a Stock Market Genius,” writes that structural inefficiencies in the capital markets cause small-cap stocks to be undervalued and generate above-normal returns:

It doesn’t pay for Wall Street analysts to cover stocks unless they can generate enough revenue (read commissions or future investment banking fees) to make the time and effort involved worthwhile. Therefore, smaller capitalization stocks whose shares don’t trade in large volumes, obscure securities, and unique situations are generally ignored. Ironically, the very areas that are uneconomic for large firms to explore are precisely the ones that hold the most potential profit for you.

Value investor Warren Buffett also falls in the inefficiency camp, claiming that individual investors should be able to earn 50% annual returns with small amounts of money because they have access to high-return small-cap stocks that he can no longer buy because of Berkshire’s huge asset size. 

Can’t Both Be Right?

Personally, I think both sides of the debate have merit.  Small-cap stocks are under-followed and ignored by Wall Street, which leads to investor neglect and undervaluation (i.e., inefficiency). However, it is also true that small-cap stocks are more vulnerable to severe economic shocks due to their typically higher debt load, non-existent economies of scale and scope, and their less diversified geographic footprint and customer base.  Small-caps can –- and do — go bankrupt, which sometimes has the nasty effect of turning their seeming undervaluation into no valuation.

One must also recognize the difference between the total small-cap universe and a carefully selected subset. Perhaps, as a whole, small stocks are riskier. But smart analysts like those we have here at KCI Investing (not to mention value investors like Warren Buffett and Joel Greenblatt) can eliminate this added risk by isolating only the best small-cap companies in which to invest.

Finding the Small-Cap Pearl Among Swine

Clearly, not all small-cap stocks go bankrupt in times of economic distress. Among the entire universe of small-cap stocks, some outperform the market during these times.  Wouldn’t it be great if one could isolate those small-cap stocks most likely to outperform and only invest in them?  The degree of outperformance from investing in small-cap stocks would be even higher if you could weed out the likely small-cap losers.

And small-cap losers there are. Professor Joseph Piotroski of the University of Chicago reports that less than 44 percent of small-cap value stocks outperform the market in the two years following their designation as small-cap value stocks.  In other words, the small-cap value stock universe outperforms the market despite the fact that a majority of small-cap value stocks are losers! As Piotroski states:

The success of [small-cap value investing] relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies.

Let’s face it, some small-cap stocks are cheap for a good reason – their business prospects are in decline and getting worse.  Other small-cap stocks are cheap because of investor neglect despite the fact that their financial fundamentals are solid and improving. Piotroski’s thesis is that by screening for small-cap value stocks with improving financial fundamentals, you can avoid small-cap value stocks that face continued financial deterioration and price declines and isolate those small-cap stocks that have begun a turnaround and promise significant price gains.

The first step of his screen ranks all small-cap stocks by price-to-book value and then eliminates all but the lowest 20%.  He then filters the remaining firms by nine profitability, liquidity, and operating efficiency criteria to focus on those firms most likely to outperform in the future.

Three Hidden Treasures?

Piotroski measured the returns of small-cap value stocks that met his screen criteria in relation to the returns of all small-cap value stocks between 1976 and 1996 and discovered that his screened value stocks outperformed the overall value stock universe by 7.5% annually, a huge improvement. The screening criteria are stringent, so the number of stocks that pass is typically few. For example, I ran the screen today and came up with only three names: P&F Industries (NasdaqGM: PFIN), Fuwei Films (NasdaqGM: FFHL), and NeoPhotonics (NYSE: NPTN).

Slow Down There, Pardner

A few caveats should be kept in mind, however. First, although a mechanical screen like Piotroski’s has impressive results, it is unable to screen for qualitative factors, such as strong management teams. Second, small-cap stocks are more volatile than the general market and can underperform for long periods of time. John Bogle, founder of Vanguard, points out that from 1926 through 2004 small-cap value stocks underperformed the S&P 500 in 61 out of 79 years.

So, unless your investment time horizon is decades, you should keep small-cap stocks only a moderate portion of your overall equity portfolio. James O’Shaughnessy argues in his 2007 book “The New Rules For Investing Now” that small-cap stocks will significantly outperform over the next 15 years. Yet even he recommends that small-cap stocks be limited to 35% of your equity portfolio.

And whatever you do, don’t be out of the market during January! Literally all of the outperformance attributed to small-cap stocks occurs in January. Between February and December, small-cap stocks have historically slightly underperformed large-caps.

Just the Facts, Ma’am

Let’s sum up:

1. If you want outsized returns, you must invest in small-cap value stocks.
2. All ten of the top-performing stocks of the past decade were small caps and most were value stocks. I can almost guarantee that the top-performing stocks of the next decade will be small caps as well.
3. Most small caps underperform, so the key is either finding the few small caps that will produce the 50, 60, and 70-baggers, or instead buying the entire small-cap universe to insure that you won’t miss out on the big winners.
4. Small caps have above-average volatility and can underperform for long periods, so their outsized returns may require a long timeframe to be realized.
5. Whether small caps are inherently more risky or just inefficiently priced is undecided, but investment prudence dictates that you normally limit your small cap allocation to less than half (some say 35%) of your total equity portfolio and avoid them altogether during incipient periods of severe economic distress (assuming you can foresee recessions and/or depressions – ha!)
6. Never be out of small-cap stocks during January.

Editor’s note:Uncover Warren Buffett’s secret to making 50% a year in the market in our free report, The 4 Secrets of Top Value Investors.