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.

Behold! My own personal whisper-stock-party-tip rumor mill. One day, it's 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.

Could these be the world's greatest stocks?
A while back, I made the case for Wall Street's worst-kept secret. It's that small-cap stocks outperform large caps over time -- and that successful stock investors own them. What, then, is Wall Street's best-kept secret?

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 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 do it for them.

So, do you really love this stuff?
This occurred to me when Tom Gardner added micro caps to his Motley Fool Hidden Gems newsletter service. No offense to my rumor mill, but it's hard to find 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 old rumor mill doesn't have its place. We've stumbled aboard our share of stock rockets -- Flextronics (NASDAQ:FLEX) and Electronic Arts (NASDAQ:ERTS) leap to mind. Then again, I am still waiting for my Genta (NASDAQ:GNTA) ship to come in.

And that stands to reason. After all, weren't we just sort of winging it? We weren't particularly rigorous and the rumor mill deals largely in hopes and speculations. With Tiny Gems, the focus is on potential and value, and the picks meet the Hidden Gems criteria. They're just smaller.

But "tiny" doesn't have to mean risky
Are you aware that Sam Walton's empire once boasted a market cap of less than $30 million? Yet even then Wal-Mart made money. It was kind to shareholders, conservatively managed, and owned by obsessive founders. But Wall Street had little use for Sam Walton. Too bad.

Hindsight is 20/20, and Wal-Mart is an extreme example, but it hardly seems that this was ever a particularly risky investment. After all, the stock 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, look for 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 look twice as hard. Best of all, look for micro caps that pay a dividend, like Wal-Mart did. That 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.

Think you could never have found Wal-Mart?
How about CircuitCity (NYSE:CC) or Ameritrade (NASDAQ:AMTD)? Both were familiar names in various circles, and both made early investors rich. If you're a mall rat, you could have bought teen retailer American Eagle Outfitters (NASDAQ:AEOS) -- an original rumor mill favorite -- as recently as 1997 for a 5,000% gain.

That's the beauty of getting in early. Consider Dell Computer. Had you bought in 1990, you'd be up some 40,000%. But here's the real beauty of getting in early: Those first few doubles and triples matter.

If you'd held off just two years, say until January 1992, you'd still be sitting on a 15,000% gain. Not too shabby, but your $5,000 investment would be worth $750,000 -- paltry compared to the $2 million you'd have if you'd pulled the trigger back in 1990.

And eventually even the best companies top out. You can run out and buy Citigroup (NYSE:C) this minute. And maybe you should -- but with a market cap in the hundred billions, what are the chances this one can run up another 1,000% in value? Pretty slim.

Maybe what you need is proof
I can't promise that micro-cap stocks will continue to outperform over the next 20 years. Or that you or I can find the next big winners. I can't even say for certain that micro-cap value stocks will outperform. But they have so far.

In "Worst-Kept Secret," I noted how, since 1926, small caps have thumped large caps -- with small-cap value stocks faring best. That's according to Ibbotson Associates, who also ran the numbers for micro caps, this time from 1968 to 2002. Turns out, micro-cap value takes the cake.

Consider: $10,000 invested in micro-cap value stocks back in 1968 had grown to nearly $1,050,000 a quarter century later. Compare that to an amazing $950,000 for the same amount invested in small-cap value and a meager $180,000 for large-cap growth.

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. Though, 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?

Tom's got a regular feature dedicated to micro caps, and the Tiny Gems discussion board is superactive. Better still, accept a free 30-day to Hidden Gems. It gets you access to the full service and there's never any obligation to subscribe. Simply click here to learn more.

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

Fool writer Paul Elliott promised to keep you posted on Hidden Gems' performance. As of Jan. 5, 2005, the recommendations are up, on average, 35.3%. That's compared with 12.5% if you'd invested in the S&P 500 instead (you can see the entirescorecardwith your free trial). Pauldoes not own shares in the companies mentioned here. Electronic Arts and Dell are Motley Fool Stock Advisor picks. The Motley Fool has adisclosure policy.