Summary Investors tend to overreact to the glamorous growth companies, and expectation can lead to disappointments. Return and value exists where nobody is looking. Micro capitalization, and value companies are common places where excess returns exist. My Investment Philosophy The road to successful investing often contradicts with our tendency to act in a collective manner. Ever since the beginning of my investing career, I have always avoided the glamour stocks, the public’s picks, and the ones that your neighbor is buying. In the short run, the market is a voting machine but in the long run, it is a weighing machine. -Ben Graham Like Ben Graham said, winning in the stock market isn’t like winning the election. Popularity will be weighed out in the long run by actual performance of the company. Large Cap Growth Stocks Tesla (NASDAQ: TSLA ): (click to enlarge) Netflix (NASDAQ: NFLX ) Source: Google Finance As TSLA and NFLX illustrate, large cap growth stocks have generated tremendous returns for their shareholders in the past few years. This Time is Different These words are often uttered before the collapse of the bull market. Investors use these words to justify elevated valuations and unsustainable growth trends. The legendary investor John Templeton once said “this time is different” are the four most dangerous words in finance. I would like to bring up an example that Warren Buffett used in his 1999 presentation before the collapse of the Dot-Com bubble: Well, I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century: automobiles and aviation. Take automobiles first: I have here one page, out of 70 in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire car and an Omaha car. Naturally I noticed those. But there was also a telephone book of others. All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people’s lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, “Here is the road to riches.” So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies–themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America–and also an enormous impact, though not the anticipated one, on investors. It is critically important for us as investors to realize that a revolutionary company might not be an economical one, and a great company might not be a good investment. Popular stocks are often overvalued and dangerous because of their nature to invoke high expectations. As NASDAQ is heading toward all-time highs again with these companies leading the charge, maybe it is time for us to take a step back and think independently about the intrinsic value of these companies before blindly following the herd. Micro-Cap Value Stocks On the other end of the spectrum, we have micro-cap stocks, which have under-performed the market since 2012. PowerShares Zacks Micro Cap ETF (NYSEARCA: PZI ) (click to enlarge) Source: Google Finance Empirical Proof In the study done by Ibbotson Associates, they divided stocks into different sizes and styles and measured their returns from 1969 to 2002. The research showed that the small caps outperformed the big caps and value stocks outperformed growth stocks during the same period. Geometric Arithmetic Standard Sharpe Mean (%) Mean (%) Deviation (%) Ratio All Growth 8.79 10.72 20.25 0.21 All Value 10.99 12.31 17.08 0.34 Large-Cap Growth 8.9 10.91 20.75 0.21 Large-Cap Value 10.43 11.75 17 0.31 Mid-Cap Growth 8.88 11.09 21.88 0.21 Mid-Cap Value 13.03 14.66 19.37 0.42 Small-Cap Growth 8.2 11.04 24.77 0.18 Small-Cap Value 14.35 16.41 21.69 0.46 Micro-Cap Growth 6.47 10.2 28.66 0.13 Micro-Cap Value 14.66 17.44 24.69 0.44 The statistics show that the micro-cap value stocks outperformed the large cap growth by a stunning 5.76% a year. But why do these market segments have by far the highest returns? Reasons for out-performance These micro-cap value companies tend to have the least coverage by analysts and the least institutional ownership. They are usually companies that are very small and no one has ever heard of. Institutions and analysts do not have incentives to research the companies, and because of their hidden nature, their values are buried with their size. Moreover, most institutions are not allowed to own these small to micro caps, and if they happen to own these companies due to a spin-off, they are forced to sell the position. Another reason why these stocks tend to out perform growth stocks is that investors overreact to growth, while not paying enough attention to the boring and less liquid companies. These asset classes are a great place to start looking for enterprise investors seeking to beat the market over the long term. Source: Fama and French Research portfolios If you are not comfortable picking stocks on your own, buying a small-to-micro capitalization value ETF will enhance your returns over the long run. For example, in the past 30 years, a 10% asset allocation to small caps will increase your return of over 1%, while having a lower standard deviation. Here are some ETFs tracking other small cap value equities: iShares Russell 2000 Value ETF (NYSEARCA: IWN ) , Small-Cap Value ETF (NYSEARCA: VBR ), iShares S&P Small-Cap 600 Value ETF (NYSEARCA: IJS ). (click to enlarge) Source: Money Chimp Conclusion I am not a market timer, nor do I suggest it is currently a good time to switch from popular growth stocks to micro-cap value stocks or that there is currently a bubble in the above companies. My point is that investing is a long-term game of discovering hidden gems, as opposed to following the herd. Micro-cap value stocks have outperformed the markets in the past for a reason; allocating a portion of the portfolio to these companies may be wiser than buying popular household names during the present-day lofty valuation era.