The following recommendations are based on an incredibly useful study by Tweedy, Browne called What Has Worked in Investing. The researchers analyzed decades of stock market data to determine which types of stocks tend to have the highest returns. Their findings are simple and actionable.
Value Stocks (Stocks Purchased "Cheaply" According to a Valuation Metric)
This makes intuitive sense. If you had to guess which type of stock would outperform market averages (those that you purchased for less than you think they should be worth, or those that you think you paid too much for), you would probably guess that purchasing stocks that you got at a bargain would beat the market. If you accept the idea that prices can behave irrationally in the short-term, but will reach a fair market price in the long-term, you can see how cheaply priced securities (value) beat overpriced assets (growth) over time. The research supports this idea as well.
In one 18 year study, the 10% of stocks with the lowest Price/Book ratios had average annual returns of 14.36% vs. 6.06% for the 10% of stocks with the highest Price/Book ratios.
Another study from 1966 through 1984 broke stocks up into ten groups according to Price/Earnings ratios. The lowest 10% of stocks had a compound annual return on average of 14.08% vs. 5.58% for the 10% with the highest ratios.
In a similar study done on Price/Cash flow, the 10% of stocks with the lowest ratio had compound annual returns of 20.1% vs. 9.1% for the most expensive stocks with the highest ratios.
It also is reasonable to guess that stocks of companies with insiders, who know more about the future of the company than the general public, making large amounts of purchases will likely have prosperity coming their way. The studies support this as well.
In one two year study from the Tweedy, Browne paper, purchasing stocks showing heavy insider purchasing produced annual returns of 45.8% vs. 15.3% for the index.
Beaten Down Stocks With Fallen Prices
Again, if you accept the idea that stock prices are irrational in the short-term, but fairly reflect asset values in the long-term, it makes sense that purchasing stocks that have fallen in price will perform those that have recently climbed in price.
Researchers looked at the thirty highest-returning and thirty lowest-returning stocks from a ten year period. In the following four years, the 30 suffering stocks returned 30.84% vs. 13.32% for the 30 that originally did well.
Small Market Caps
It also makes perfect sense that large companies have less room for explosive growth than do tiny companies, with the potential to turn into giants. Tweedy, Browne showed this true as well in their research.
In one study, the smallest market capitalization stocks had an average annual return of 32.8% vs. 13.0% the biggest stocks. Very exciting!
Example of a Fund Using These Principles
Vanguard has a fund called the Vanguard Small Cap Value Index Fund (VISVX) that purchases companies with small market capitalizations at discount prices. It is also very cheap to maintain, with an expense ratio of only 0.24%.