You know who you are. I've been knocking around this business for years, and everywhere I've stopped I've met you. And every time I turn up someplace new, I take one or two of you along with me. At least in spirit.

Behold! My own personal whisper-stock-party-tip rumor mill. One day, it's a call from Mark in Rockville. Then it's Sean from Miami or Shannon from Boston. And just when you think you've heard it all, it's the other Mark from New York. He's got to be the worst of the lot.

The greatest stocks of all
A while back, I made the case for Wall Street's Worst-Kept Secret. In a nutshell, it's that small-cap stocks tend to outperform their larger-cap peers over time -- and that successful stock investors own them. What, then, is Wall Street's best-kept secret?

I'll spare you the drumroll. It's that micro caps do even better. At least a certain type of them do. In a bit, I'll back that up with some hard numbers. Heck, I'll even toss in a few anecdotes, but first some fine print.

Unlike small caps -- say, anything with a market cap between $150 million and $2 billion -- micro caps are not for everyone. They're for people like Sean and Shannon and the Marks. They're for people who love this stuff -- serious investors who have the time and inclination to do some real digging. Or have someone they trust to do it for them.

Tiny Gems
This occurred to me when Tom Gardner began featuring micro caps in his Motley Fool Hidden Gems newsletter. No offense to my rumor mill, but it is hard to find detailed -- dare I say trustworthy -- research on tiny companies. Not even the boutique shops offer much by way of coverage.

Which isn't to say that the old rumor mill doesn't have its place. We found ImClone (NASDAQ:IMCL) in the single digits back in 1997. It's been a wild ride, but we had opportunities to sell for huge gains (I did sell some at around $50 a while back, but apparently not enough.) Then again, we also turned up Genta (NASDAQ:GNTA), which I hold to this day as a painful reminder of what can go wrong.

That our results have been mixed only stands to reason, I guess. After all, we were in a sense just winging it. Our method was never particularly rigorous and the rumor mill deals largely in high hopes and speculations. With Tiny Gems, the focus of the search is potential and value, and the results meet the rigorous Hidden Gems criteria. They're just smaller.

Poor little Wal-Mart?
Can you imagine that Sam Walton's empire once boasted a market cap of less than $30 million? Yet even then the company made money. It was shareholder-friendly, conservatively managed, and heavily owned by obsessive founders. But Wall Street's investment banks had little use for Wal-Mart. Too bad.

Had you invested $5,000 back in 1980, you'd be sitting on about $2.5 million today. Hindsight is 20/20, and Wal-Mart is an extreme example, but it hardly seems that Wal-Mart was ever a particularly risky investment. After all, it actually paid a dividend, even when it was a small fry.

The trick, obviously, is to find companies today with the characteristics of a 1980s-era Wal-Mart. As with any small cap, insist on these in any micro cap:

  • Solid management with significant stakes
  • Great, sustainable businesses
  • Dominant positions in niche markets
  • Sterling balance sheets
  • Strong free cash flow

Just insist twice as hard. Because contrary to how investors behave, the smaller the company, the more important these things are. Best of all, look for micro caps that pay a dividend, like Wal-Mart did. A dividend implies a lot of good things, including that the company won't be out begging for new capital -- a great sign if ever there was one.

Many fish in the sea
Think you could never have found Wal-Mart? How about Home Depot (NYSE:HD) or Lowe's (NYSE:LOW)? Both looked pretty solid by 1990. If you'd bought them then, you'd be sitting on 2,000% and 7,000% gains, respectively. You could have bought American Eagle Outfitters -- an original rumor mill favorite -- as recently as 1997 for a 5,000% gain.

That's the beauty of getting in early. The rise and fall of AOL (NYSE:TWX) is the stuff of legends. Investors who bought AOL at its peak have been sorely disappointed. Those who bought it back in 1990 are still sitting on obscene profits. And then there is Dell (NASDAQ:DELL). Had you bought Dell in 1990, you'd be up some 40,000%.

Here's the real beauty of getting in early: Those first few doubles and triples matter. If you'd held off on Dell just until January 1992, you'd still be sitting on a 15,000% gain. Not too shabby, but consider that your $5,000 investment would be worth $750,000 -- paltry compared to the $2 million if you'd pulled the trigger back in 1990.

Companies invariably reach a critical mass. You could buy Intel (NASDAQ:INTC) this minute. And maybe you should -- but it can't be the next Intel. With a market cap in the hundred billions, what are the chances Intel can run up another 1,000% in value? Pretty slim.

What you need is proof
Of course, I can't claim with any certainty that micro-cap stocks will continue to outperform over the next 20 years. Or that we can find the next big winners. I can't even promise that micro-cap value stocks will outperform. But they have done so in the past.

In "Worst-Kept Secret," I made a point of how, since 1926, small-cap stocks have thumped large caps -- with small-cap value stocks faring best. That's according to Ibbotson Associates, which also ran the numbers for micro caps, this time from 1968 to 2002. Turns out, micro-cap value stocks take the cake.

Consider: $10,000 invested in micro-cap value back in 1968 had grown to nearly $1,050,000 a quarter century later. Compare that to around $950,000 for the same amount invested in small-cap value (which, remember, is downright phenomenal) and a mere $180,000 for large-cap growth.

Ride the tiger
For all that, micro caps are for investors who can stomach a little volatility. OK, a lot of volatility. The stocks of smaller companies are simply more jumpy than all others. There are reasons for this, ranging from low liquidity to uneven news flow to execution glitches associated with rapid growth and sensitivity to the business cycle. Volatility? Expect it.

And when it comes to business or company risk -- heck, even sector risk -- it pays to diversify. My pal Rex Moore here at Fool HQ says to allocate "one full stock position" to a basket of micro-cap stocks. I can't promise I will muster that kind of discipline myself, but I certainly see the value in it. Just be careful.

And here's a crucial point: If you're indexing, you'd better stick with value. There are big winners among the richly valued high growers, but buying micro caps with big P/Es or with no earnings is exponentially more risky. Those Ibbotson numbers I gave you before were for micro-cap value stocks.

Not coincidentally, the same holds for my real-life examples, too. The Hidden Gems approach is to look for growth potential and real earnings -- at a reasonable price. I'm betting that sounds like a whole lot of fine print, warnings, and disclaimers. But did I mention the potential rewards? Out of this world.

Don't think performance doesn't count
I promised to keep you posted on Hidden Gems' performance. As of April 14, 2005, the recommendations are up, on average, 26.3%. That's compared to 5.88% if you'd invested in the S&P 500 for the same period. For context, that's more than 40 picks over nearly two years.

As for Tiny Gems, here are some unofficial results: As of March 24, the 16 Tiny Gems featured since May 2004 were up 8.4% on average. That's compared to a 2.9% gain for the S&P 500 and 0.8% for a very solid Bridgeway Ultra-Small Company Market Fund. As always, thanks for crunching the numbers, FoulWeather.

What to do now
You can bet I will follow up on this thread. Micro caps may not be for everyone, but they sure are a blast. And there sure is a lot to talk about. But it's not exactly rocket science, either. More than anything, just promise me you'll keep your head... and diversify.

Or why not check out what's going on at Hidden Gems? There's a regular feature dedicated to micro caps, and the Tiny Gems board is superactive. Best of all, Tom Gardner is offering a free 30-day trial -- that way you can see if it's right for you without betting the farm. Click here to learn more.

This commentary was originally published on Feb. 4, 2005. It has been updated.

Fool writer Paul Elliott owns ImClone and Genta. The Motley Fool has a full disclosure policy.