There is a reason I have part of my portfolio invested in small companies. Many reasons, actually, and I'll share a few of them with you.

Some are obvious. Intuitively, we know that if we're going to be fortunate enough to achieve Wal-Mart-type gains with any of our investments, they will come from a smaller company. If I'd been smart enough to drop $1,000 into Sam Walton's then-small retail chain after graduating from high school in 1977, it would have turned into more than a million bucks by now. So, while large companies have a place in everyone's portfolio, it's safe to say that they won't deliver these kinds of supercharged returns. For instance, I own Procter & Gamble (NYSE:PG) and Microsoft (NASDAQ:MSFT), two giant companies. I expect market-beating returns from them over the next couple of decades, but neither will appreciate 1,300 times in value over the next 20 to 30 years, as Wal-Mart once did. And neither will Wal-Mart. Only small companies have that potential.

But let's consider some less obvious reasons why we should all try to "think small."

Wrong price tag
Let's look at two companies, semiconductor giant Intel and little Alderwoods Group (NASDAQ:AWGI), which operates funeral homes and cemeteries.

A total of 39 analysts cover Intel, and thousands of experts dissect its every move in news stories, Internet blogs, and discussion boards. The Motley Fool's Intel discussion folder contains more than 50,000 posts, offering some of the best analysis anywhere. Though its business is somewhat complicated, you'll find Intel experts on every street corner. Its stock, which trades about 70 million shares per day, may very well be over- or undervalued. But it's also fair to say that it is somewhere in the neighborhood of fairly valued. Or at least in the same city.

By contrast, Alderwoods draws exactly one analyst. Weeks can pass before a news story about it crosses the wire. Very, very few people outside the company have a thorough understanding of the business. What are the chances that its stock price is correctly valued? It's possible, but the price also could be so far from fair that it's not even in the same country.

Alderwoods was first selected by guest analyst Tom Jacobs in the Hidden Gems newsletter in November 2003 and was re-recommended by Tom Gardner shortly thereafter. Both felt the market was not recognizing management's ability to turn the company around after emerging from bankruptcy. They've been right so far, with the stock up 82% since the initial selection, vs. the market's 15% rise.

Be the cream
Another reason to like small caps dovetails nicely with the point above. We've seen why small companies are more likely to be mispriced than large ones. But mispricing goes in both directions, meaning a small-cap stock could be either wildly undervalued or overvalued. You need to be able to separate the winners from the losers.

Because fewer analysts, institutions, and individual investors follow small companies, you are more likely to benefit from the knowledge that comes from solid, detailed research. After all, every stock transaction involves a buyer and seller. The person most likely to benefit in that transaction is the one most knowledgeable about the company! Because they must invest huge sums to benefit their portfolios, masters like Warren Buffett simply can't buy small caps. With fewer brilliant minds looking at these companies, you and I can be the cream that rises to the top.

The perfect example is Internet travel advertiser Travelzoo (NASDAQ:TZOO). In the past year alone, it has risen 1,000%... and then lost nearly three-quarters of its value. With no analysts providing research, the winners and losers on each transaction will likely be the ones with greater knowledge of the company's true value.

Favorable research
Finally, there is solid evidence that, as a group, small caps tend to outperform large caps. In his book Investment Fables, NYU Stern School professor Aswath Damodaran pulls together research pertaining to various investing strategies. Using data from Gene Fama and Ken French, Damodaran found that smaller stocks earned higher average annual returns than larger stocks of equivalent risk for the period 1927-2001. When comparing the smallest subset of stocks to the largest, the difference is considerable: 20% vs. 11.74% on a value-weighted basis, with an even greater difference on an equally weighted basis.

Of course, there were many periods when large caps outperformed small caps, as there will be in the future. But on average, small caps offer higher returns.

An interesting side note: Damodaran also cites research that the fewer analysts covering a company, the higher the returns tend to be -- even after adjusting for the fact that smaller firms draw less analyst coverage than larger ones.

In sum
So, those are some of the reasons I seek out small caps for a portion of my portfolio -- and why you should consider doing so also. Unless you're an expert and have faith in what you're doing, they should not dominate your portfolio. They do carry more downside risk than stable, blue-chip companies do. But reserving 10% to 20% of a well-rounded portfolio for these small guys can certainly pay off in the long term.

If you're interested, we're offering a free trial to Hidden Gems. Tom and his analysts have been actively seeking out small, mispriced companies since the newsletter's inception in July 2003. Thus far, they've achieved 23% average returns for their recommendations, vs. 4% for money similarly invested in the S&P 500. Try it for free for 30 days. If it's not to your liking, it won't cost you a dime.

This article was originally published on Feb. 25, 2005. It has been updated.

Rex Moore is lovin' baseball season. He owns shares of Procter & Gamble and Microsoft. The Motley Fool is investors writing for investors.