Over the past two-and-a-half years, stocks recommended by the Motley Fool Hidden Gems small-cap investing newsletter have outperformed the S&P 500 stock market average by 20 percentage points.

Humility trumps hubris
That's a boast. Grounded in facts, certainly, because we have the numbers to back it up. But there's no denying that when we tell you how well our newsletter's recommendations have done, we're definitely tooting our own horn. So let's give credit where credit is due and reflect for a moment on how Hidden Gems became so successful. Because we didn't get here all on our own.

Study the masters
The secret to Hidden Gems' success is this: We stand on the shoulders of giants. The fact that we're beating the market averages owes at least as much to our study of the world's great investors as it does to the stock-picking wizardry of Tom Gardner and his merry team of hunters. Over the years, we've read -- and we've recommended to our members -- all the standard investing classics:

  • Ben Graham's The Intelligent Investor
  • Peter Lynch's One Up on Wall Street
  • Philip Fisher's Common Stocks and Uncommon Profits

But our competition, out there in investing-land, has read all of these, too. They know the rules of "buy under book value," "buy what you know," and "never sell." And so, to beat them, we go further. In our continuing quest to help individual investors become wealthy individual investors, we've also researched the investing strategies of:

  • John Neff, the manager who took over Windsor Fund at age 32 and revived this broken franchise, leading it to 32 years of trouncing the S&P with bold, contrarian picks like DaimlerChrysler.
  • Shelby Davis, the New York insurance analyst who grew a $50,000 account into nearly $900 million over five decades of investing in good times and bad.
  • Hetty Green, the 19th-century investing maven who over a lifetime of investing in stocks built a fortune valued at $20 billion in today's dollars.

Neff, Davis, and Green, as well as dozens of other very successful but poorly publicized personages, are the unsung heroes of the individual investor. These are the teachers we study. These are the inspiration and the source of our success.

Through continual study of these investing giants (both the famous and the not-so-much), we've distilled the wisdom of the masters down to a few simple rules that, in spite of our small size and wingtip-less background, have enabled Hidden Gems to crush the Street for two years running (and counting). Today, we're sharing them with you.

Must have cash
A company in debt makes investors fret. When interest rates rise, so, too, does the cost of servicing debts -- and that saps strength from profits. If you own shares of New York Times (NYSE:NYT), which -- in addition to facing a difficult operating environment -- carries more than $1 billion in net debt, be wary of the Fed. The same goes for owners of Warner Music Group (NYSE:WMG) -- $288 million in cash and $2.2 billion in long-term debt -- and Domino's Pizza (NYSE:DPZ) -- $22 million in cash and $752 million in debt. Conversely, shareholders of a company like American Eagle (NASDAQ:AEOS) -- whose treasuries brim with more than $550 million and no debt -- can rest a bit easier.

Must have real profits
Heed the words of Third Avenue Value fund manager Marty Whitman: "What the numbers mean is more important that what the numbers are." In this sense, "what the numbers are" is profits under generally accepted accounting principles -- and Enron taught us how truly malleable such numbers can be. The savvy value investor prefers companies that generate cold, hard cash profits -- free cash flow. While pleased to see that Dell (NASDAQ:DELL) has $3.2 billion in net income over the past 12 months, he'd have focused more (and even more happily) on the more than $5 billion in actual cash on the company's cash flow statement.

Must have owner-operators
You tell me: Would shareholders of Tyco be better off today if Dennis Kozlowski and his gang had owned more than a fraction of 1% of the company they were robbing? When a company's managers own a stake in the business -- what we call "insider ownership" -- this creates a real disincentive to steal. Owner-operators of a business are natural allies of outside shareholders; when the business prospers, everybody wins. That's why, when researching potential Hidden Gems, we prefer companies such as Cerner (NASDAQ:CERN). Cerner has grown revenue more than 19% per year for the past 10 years, and CEO Neal Patterson owns 10% of the business. It's no coincidence that the stock has roughed up the S&P by six percentage points on average over the same time frame.

Must have large font
The most recent 10-K filing for energy giant ConocoPhillips (NYSE:COP) ran to more than 200 pages, replete with discussions on patents, reserves, price forecasting, and agreements with various governments around the world. While ConocoPhillips deserves credit for its thoroughness, there is simply no way to put a confident value on this company or account for all of the risk scenarios. Meanwhile, little Blackboard, an educational software company whose stock is already up more than 60% in seven months on the Hidden Gems roster, offers its investors a mere 63 pages of reading material. Heck, with all that space, the company could go wild and print its financials in easy-to-read 12-point font -- and investors would still have less paper to plow through. More important than the font size, though, is the fact that smaller companies like Blackboard are transparent. Fewer pages mean fewer places to hide inconvenient facts. It means we're less likely to be surprised, and less likely to invest in something we do not understand.

Must (not) have sex appeal
And while we're on the subject of things we don't understand -- satellite radio, anyone? -- how about nano-stem-fuel cells? Companies like WorldSpace, Altair Nanotechnologies, ViaCell, and Ballard have two things in common: They're all "hot" stocks and they're all losing money hand over fist. At Hidden Gems, we leave the fast money to the day traders and stick to our knitting -- finding great, profitable, unknown companies that make for great, profitable, who-cares-if-you-know-about-it-it-made-me-rich investments.

And you can, too. Just click right here and sign up for 30 free days of Hidden Gems, and you'll have access to our entire list of more than 50 picks, plus two brand-new ones when the next issue comes out. That's 50-plus cash-rich, profitable, owner-run, easy-to-understand, and boring-as-all-get-out companies, all for one low price -- nothing.

Of course, if you find you like what we have to offer, we'd love to have you stick with the service. But we have a firm policy around here: If you aren't thrilled with Hidden Gems, you may cancel at any time -- no strings attached. So have no fear; sign up right here.

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

Fool contributor Rich Smith does not own shares of any company named above. If he did, we'd make him tell you about it. Dell is a Motley Fool Stock Advisor recommendation.