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 numbers. Heck, I'll even toss in a few anecdotes, but first some fine print.

Unlike regulation small caps, 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 -- 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 added micro caps to his Motley Fool Hidden Gems newsletter service. No offense to my old 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. Believe me, I've looked.

Which isn't to say that the rumor mill doesn't have its place. I mean, we dug up a few killers over the years. We even stumbled aboard the occasional stock rocket -- Flextronics (NASDAQ:FLEX) and Electronic Arts (NASDAQ:ERTS) come to mind. Then again, I am still waiting for my Applied Digital (NASDAQ:ADSX) ship to come in.

That our results are 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 CircuitCity (NYSE:CC) or Ameritrade (NASDAQ:AMTD)? Both are familiar names in various circles and both made early investors fortunes. If you're more of a mall rat, you could have bought teen retailer 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 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. 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 run out and buy Citigroup (NYSE:C) or ExxonMobil (NYSE:XOM) this minute. And maybe you should -- but neither can be the next big winner. With market caps in the hundred billions, what are the chances these guys 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 May 12, 2005, the recommendations are up, on average, 28.1%. That's compared to 5.1% 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 April 30, the 18 Tiny Gems featured over the past year were up an average of 3%. That's slightly better than a flat S&P 500 and considerably ahead of the -3.9% turned in by a very solid Bridgeway Ultra-Small Company Market Fund. As always, thanks for crunching the numbers, FoulWeather.

What to do now
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 rattle Tom Gardner's cage at Hidden Gems? He's got a regular feature dedicated to micro caps, and the Tiny Gems board is superactive. Best of all, Tom is offering a free 30-day trial that gets you access to the entire service. That way you can see if it's right for you without dropping a dime. Simply click here to learn more.

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

Fool writer Paul Elliott (still) owns Applied Digital. The Motley Fool has a full disclosure policy.