If you invest in stocks for the long term, you must own small-cap stocks.

There, I said it. But come to think of it, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, smaller-company stocks outperform their mid- and large-cap peers, so smart investors own them. Period.

Only what you need
I'll back that up with some hard data, but first let's talk about you. You are serious about this stuff; otherwise, you wouldn't still be reading. You also want an edge -- a secret -- that will help you do better than the average investing Joe. We all do.

So why make this harder than it needs to be? Investors who make out over the long term hold diversified portfolios of common stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. Stock investors who make even more buy small caps, also according to Ibbotson.

Sticking with our "simple" theme, here's how I see it. You can buy a small-cap fund that keeps its costs in check, though the good ones are as hard to get into as a decent preschool. You can ...

  1. Buy one of a growing number of great small-cap exchange-traded funds (ETFs).
  2. Take your chances on a small-cap mutual fund that's open for business.
  3. Seek out -- with or without the help of a trusted advisor -- the very best smaller companies and build a small-cap portfolio of your own.

You're a Fool ...
... And so am I. We favor the do-it-yourself approach. Well, sort of. I've been around, and I own my share of small caps. But I also have the occasional cup of joe with Motley Fool co-founder Tom Gardner, who works 24/7 digging up well-run companies for subscribers to his Hidden Gems small-cap advisory service -- and he never shuts up about it.

So I think about this a lot. And you know what? For better or for worse, Tom's more disciplined, strict value approach has created a portfolio of small-cap gems I wouldn't have built on my own. One that -- gun to my head, and assuming I'm in it for the long term -- I would swap straight up for mine. There, I said it again.

For all that, Tom and I look for many of the same things in a great small company. It's what the all-time great value investors have always looked for. For more detail on this, check out my mild rant, "How to Beat a Choppy Market." But here's the short list for now:

  1. Solid management with significant stakes.
  2. Great, sustainable businesses.
  3. Dominant positions in niche markets.
  4. Sterling balance sheets.
  5. Strong free cash flow.

It's hard to imagine it now, but these are the very traits that put former tech bantamweights Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC) near the top of the market-cap heap. Hard as it is to imagine, you can even trace Citigroup (NYSE:C) to Sanford Weill's Commercial Credit Company, which you could have owned right through Travelers Group to the $225 billion monster it is today.

Good work if you can get it
I know what you're thinking: Who in his right mind wouldn't want a portfolio filled with stocks like that? And you're right. That's precisely the problem with trying to beat the market pros with well-known, large-cap stocks -- if they're really all that, they're going to cost you. How much? An efficient market theorist would say just enough. I'd argue too much.

But what's the alternative? Taking a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks, not well-known companies. Sometimes there's a difference. Eventually, big consumer names like Target (NYSE:TGT) and Costco (NASDAQ:COST) hit Wall Street's radar hard, but it takes a while. And there are always dozens of established, profitable companies with lesser-known stocks.

Some of these you've heard of, some you may not have -- yet. Some even dominate their markets. Peter Lynch was a master at finding these stealth bombers. That's a big reason why he earned his Fidelity Magellan fundholders nearly 30% per year. With a little work, you can do it, too.

Yes, you can
Here's how I know. I myself stumbled upon Harley-Davidson the stock after having seen (and heard!) the bikes for years. At about the same time, I was shocked to learn -- in a hospital of all places -- that upstart medical device makers like Guidant (NYSE:GDT) were wrestling with the likes of Johnson & Johnson (NYSE:JNJ) for a share of a $25 billion market.

In fact, it can take years for a stock to cross the big boys' radar, even if they swear by the company's products themselves. And when it does, it usually hogs the radar screen long after it should have blipped off. That gives us a great advantage as individual investors. We have plenty of time to find these stocks and buy them as small caps before the big money drives them to the stratosphere.

Take your time
Back in September 2003, I suggested you get the ball rolling with a hard look at a pair of small-cap ETFs. I bought the iShares S&P 600 Growth Index (IJT) myself at about $65 earlier in the year and was thrilled with my returns. I pledged to buy the sister fund iShares S&P 600 Value Index (IJS) next -- a promise thankfully kept.

In just the year and a half since, the growth fund is up another 40%. The value fund has fared even better. I don't bring this up now to brag, but to make two points: First, all who said that the small-cap rally was over back in September 2003 (and they were many) were wrong. (My hunch is there are even more saying it now -- and that they're still wrong.)

More importantly, these funds trade like stocks, so they offer you quick and dirty (and diversified) small-cap exposure without the risk -- perceived or otherwise -- of taking the plunge on the stocks of individual companies. The strategy of holding the funds, then shifting into Tom Gardner's Hidden Gems after digging around at your leisure, strikes me as sound. As does simply holding the funds as a means of diversifying your small-cap exposure.

Buy the numbers
According to market-data king Ibbotson Associates, since 1926 small-cap stocks have delivered annual returns of 12.4%. That's compared to 10.7% for large caps. Put another way, $5,000 invested in small-cap stocks and left to sit would grow into about $52,000 over the course of 20 years. Imagine if you'd been adding to your position along the way. Nice.

And that's overall. In periods when small caps do outperform, they seriously outperform, and they tend to do so for periods lasting -- depending on whom you ask -- from five to seven to 10 years or more. Frankly, I don't think the small-cap run is over. Either way, it's axiomatic: Today's giants sprouted from well-run small companies, taking smart investors along for a swell ride. So will tomorrow's.

What to do now
If you want to learn more about Tom Gardner's approach to beating the market with small-cap value, now's the time. Tom is offering a special free trial to his Motley Fool Hidden Gems advisory service. You can take it up directly with him and sneak a peek at all his past picks. Simply click here to check it out.

Meanwhile, I promised to keep you posted on Hidden Gems' performance. As of September 1, 2005, the recommendations are up, on average, 28.5%. That's compared to 9.3% if you'd invested in the S&P 500. For context, that's more than 50 picks over more than two years. As always, you can view the entire scorecard with your free trial.

This article was originally published on Jan. 7, 2005. It has been updated.

Fool writer Paul Elliott owns none of the stocks mentioned. The Motley Fool has a full disclosure policy.