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Choose David Over Goliath

However, had you employed Greenblatt's strategy over that same timeframe, screening through all 3,500 stocks with a market-cap over $50 million, your annualized return would have been 30.8%, about eight percentage points better, which is a very substantial margin.

Picking individual names in the small-cap world requires some work and some common sense. Avoid highly leveraged balance sheets. Look for stable businesses with high earnings and cash flow yields that have a track-record of delivering returns to shareholders. Understand the underlying business that drives the company and have some confidence in its prospects to thrive in the future.

How do you find them? Small-cap stocks are probably best found through word of mouth, or from a writer who has earned your trust.

You could start by taking a look at companies that have been on my radar a while, including L.B. Foster (FSTR), Gentex (GNTX) (with a market cap close to $3 billion, it's more of a mid-cap, I suppose), and also the Canadian gold-streaming company Sandstorm Gold (SAND).

Or, you could just follow Greenblatt's "Magic Formula." That's not as much fun, though.

At the time of publication the author had a position in SAND but doesn't own shares in any other stocks mentioned in this article.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
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