You know who you are. I've been knocking around this business for years, and everywhere I've stopped I've met you. And when 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 Mark on the line from Rockville. Next 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.

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 you can do even better with micro caps. At least a certain type of them. I'll back that up with some hard numbers. I'll even toss in a few anecdotes, but first some fine print.

Micro caps are not for everyone. They're for folks 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.

Who wants Tiny Gems?
This occurred to me when Tom Gardner began featuring micro caps in his Motley Fool Hidden Gems newsletter. I'd been a fan of the smaller stocks on Tom's Watch List, but I needed more detail. No offense to my rumor mill, but it's tough to find reliable information on tiny companies.

Which isn't to say the old gang didn't score, but our results were mixed. For every Electronic Arts (NASDAQ:ERTS) or Activision (NASDAQ:ATVI) we hit out of the park, we whiffed on a North Face (sadly, ticker not found!). And why not? We were sort of winging it. With Tiny Gems, the focus is on potential andvalue. The rumor mill deals largely in speculations.

Poor little Wal-Mart?
It's true. Sam Walton's empire once boasted a market cap of less than $30 million. Yet even then Wal-Mart made money. It was shareholder-friendly, conservatively managed, and heavily owned by insiders and obsessive founders.

Good for them -- and for us. If you'd dropped $5,000 in Wal-Mart in 1980, you'd be sitting on about $2.5 million today. Of course, hindsight is 20/20, but it hardly seems that Wal-Mart was a particularly high-stakes gamble. For one thing, it paid a dividend, even when it was a small fry.

Admittedly, that's a lot to ask of a $30 million company. But as with regular small caps, do insist on these in any micro cap:

  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.

Just insist twice as hard. Because the smaller the company, the more diligent you have to be. And do keep your eyes out for those that pay a dividend, like Wal-Mart did. A dividend implies many 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
It's not just Wal-Mart. Household giants from Costco (NASDAQ:COST) to Comcast (NASDAQ:CMCSA) once shared many of these same traits. Speaking of households, you could have bought Pulte (NYSE:PHM) -- an original rumor-mill find -- as recently as 1995 and be sitting on 1,100% gains. (I know, it doesn't seem possible.) And then there's everybody's favorite, Dell.

Had you bought back in 1990, you'd be up some 40,000%. But notice, those first few doubles and triples matter. If you'd held off 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 with the $2 million if you'd pulled the trigger back in 1990.

Think of it this way: You could buy a Pfizer (NYSE:PFE) or Bank of America (NYSE:BAC) this second. And maybe you should (I recently bought both myself). But neither can be the next big thing. With market caps in the hundreds of billions, what are the chances either one of those can run up another 1,000% in value? Pretty slim.

What you need is proof
I can't claim with any certainty that micro-cap stocks will continue to outperform over the next 20 years. Or that you 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.

It turns out $10,000 invested in micro-cap value back in 1968 had grown to nearly $1,050,000 a quarter-century later. Compare that with around $950,000 if you'd invested in small-cap value (which, remember, is downright phenomenal) and a mere $180,000 for large-cap growth.

Ride the tiger
For all of that, you'd better expect a little volatility. OK, a lot of volatility. Small-company stocks 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, 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 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.

What to do now
Micro caps may not be for everyone, but they sure are a blast. Catching just one big winner gives you and your rumor mill something to talk about for years. But fear not -- it's not exactly rocket science, either. More than anything, just promise me you'll keep your head ... and diversify.

Or why not try this? You can try out Hidden Gemsfree for 30 days. Tom's got a regular feature dedicated to micro caps, and the Tiny Gems discussion board is superactive. Best of all, your trial is free -- that way, if you're not blown away, you just drop it. Click here to learn more.

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

Fool writer Paul Elliott promises to keep you posted on Hidden Gems' performance. As of Oct. 13, 2005, the picks are up, on average, 20.2%. That's compared with 4.9% if you'd invested in the S&P 500 instead. Paul owns shares of Bank of America and Pfizer. Pfizer is a Motley Fool Inside Value recommendation. Electronic Arts, Costco, and Activision are Motley Fool Stock Advisor recommendations. The Motley Fool has a fulldisclosure policy.