While it seems like the whole world is investing in stocks that trade in the major market indexes, sometimes winners can be found on the path less traveled.
It's easy to see why investors are flocking to index-traded stocks. When a stock joins a major market index like the S&P 500, there is often celebration. It almost certainly means an immediate boost to the price and adds to the perception that the company has a promising outlook.
Index stocks also benefit from a boost in liquidity. They immediately get bought up by all funds tracking the index and anyone who is trying to mimic it.
Exchange-traded funds, which track market indexes, hauled in a record $29 billion in August alone. Since the beginning of the year, these popular low-cost portfolios have brought in $300 billion in investor money, which is already more than double last year's blistering pace.
But index investing can have some risks. For starters, the S&P 500 and other major indexes weight their holdings by market cap, which means the largest companies have the biggest influence. The S&P and its cousin, the Dow Jones Industrial Average, have been on a steady march higher this year largely because of gains in a handful of high-profile technology stocks.
This also means investors could find themselves overexposed to a small number of large companies. And the perception that index constituents have better long-term prospects? The Federal Reserve Bank of New York looked into it and found it made no difference.
"We find that the firms included in the S&P 500 index are characterized by large increases in earnings, appreciation in market value, and positive price momentum in the period preceding their index inclusion," the report said. "Contrary to the consensus in the literature, our results indicate that -- after accounting for the firms' extraordinary pre-inclusion performance -- index inclusion has no permanent effect on value."
Perhaps indexing's biggest weakness is its very setup. Unlike an actively managed fund, which can pick and choose which stocks to sell at any given time, an index fund has to follow the direction of the market it's tracking. This is good news when the market is going up, but could be bad news in a market downdraft.
Avoiding that means hunting for value in stocks that aren't in the indexes, to spread your risk around. It's not as hard as it would seem to find them. One famous example is Tesla (TSLA) , which isn't in the S&P 500 even though the electric-car maker is as big if not bigger than S&P constituents Ford (F) and General Motors (GM) .
Tesla, which happens to be the largest company outside the S&P 500, might get added eventually, but not until it meets the indexer's criteria that it be GAAP profitable, which might not be until sometime next year. It is in the broader Russell 1000, however.
Another famous example is Snap (SNAP) , the parent of the ephemeral-message social media site Snapchat. The stock debuted earlier this year and hasn't done well. But S&P decided it wouldn't add it and other stocks of companies that have multiple share classes (while grandfathering stocks that are already in the index).
There are also stocks that have been dropped from the indexes, for a variety of reasons, including bankruptcy and mergers. In addition, stocks of old-guard companies like Eastman Kodak (KODK) and Dell got replaced by newer high-fliers like PayPal (PYPL) and Under Armour (UA) .
Earlier this year, the S&P dropped shares of the apparel retailer Urban Outfitters (URBN) , the telecommunications company Frontier Communications (FTR) and renewable energy company First Solar (FSLR) .
And there are a bunch of companies that are in the Russell 1000 but not in the S&P, including T-Mobile (TMUS) and Sprint S, telecommunications companies that have been flirting with a merger, and Sirius XM Holdings (SIRI) .
Here are three "orphan" stocks that aren't in either the S&P 500 or the Russell 1000 but show promise as good values based on our models tracking the investment style of famous investors.
Check Point Software (CHKP) -- A play in network security, this stock scores highly on our model tracking growth investor Martin Zweig. The company has reasonably steady earnings and a multiple, at 25, that isn't too far ahead of the market's overall multiple of 20.
Ares Capital (ARCC) -- This specialty finance company in the growing middle-market niche fits the model tracking James Piotroski, who looks for smaller companies that are flying under the radar and show improving fundamentals. The stock has a healthy 9.6% dividend yield and positive return on assets.
AerCap Holdings (AER) -- This aircraft leasing company also scores well on the model tracking Zweig and that of legendary investor Peter Lynch. The company has been growing earnings nicely over both the short and longer terms, a quality Zweig looked for, while the Lynch model favors the stock's valuation when compared to the firm's profit growth rate.