Choose David Over Goliath

NEW YORK ( TheStreet) -- Small-cap stocks are generally riskier than large-caps, but value investors that are willing to do a bit of homework should focus most of their efforts on them anyway.

Large-cap names, such as Apple ( AAPL) and Exxon Mobil ( XOM), dominate the financial news because media companies are trying to capture the widest audience possible. They also garner the most attention from the major fund managers, who are typically restricted from buying stocks with a market cap below $1 billion.

As a result, most investors own large-cap stocks, but following the herd is rarely part of a great investment strategy. Small-caps offer more fertile ground for the studious stockpicker precisely because they are lesser-known quantities. This is a fact the small investor should wield to his or her advantage.

Yes, the data suggest that ignoring small-caps is folly. From 1926 to 2011, small-cap stocks had annualized returns of 11.3% compared with 8.9% for large-caps, according to Morningstar.

Remember the "Lost Decade" for stocks -- the period of time between the bursting of the dot-com bubble and the collapsing of the U.S. housing bubble when the S&P 500 lost ground over the course of a decade? Well, the Russell 2000 Small Cap Value Index was up more than 60% during that period. The S&P MidCap 400 and the S&P SmallCap 600 were both up over 60% as well.

My favorite data point favoring small-caps is provided by author Joel Greenblatt, inventor of what he calls "Magic Formula Investing" , which allows investors to beat major market averages over time by sticking to a quantitative stock-investing formula that screens stocks for those with the lowest price coupled with the highest cash-flow yield.

I love Greenblatt's strategy, partly because it proves how utterly useless many Wall Street professionals are, but also because it takes the element of human emotion out of investing, which is the element that leads most people to investment folly.

If investors had followed Greenblatt's strategy from 1988 through 2004, buying only the largest 1,000 U.S.-listed stocks on the market, they would have enjoyed annualized returns of 22.9%, nearly doubling the S&P 500's performance of 12.4% -- not too shabby (and far better than most of the professionals that would have also been charging you an arm and a leg for their "services").

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.