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

There, I said it. But that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, smaller-company stocks outperform, so smart investors own them. Period.

It's 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 be reading. You also want an edge -- a secret -- that will help you do better than the next guy. 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 ...

  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 still open for business.
  3. Seek out -- with or without help -- the very best smaller companies and build a small-cap portfolio of your own.

Hey, you're a Fool ...
... And so am I. We do it ourselves. Well, sort of. 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 like a dog digging up small caps for his Motley Fool Hidden Gems small-cap newsletter -- and he never shuts up about it.

And you know what? For better or for worse, Tom's disciplined, value approach has resulted in a portfolio of small-cap gems I wouldn't have built on my own. One that -- gun to my head -- I would swap straight up for mine. There, I said it again.

For all that, Tom and I look for the same things in a great small company. It's what the all-time great value investors have always looked for. For more 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, but these very traits put former tech bantamweights Cisco (NASDAQ:CSCO) and Intel (NASDAQ:INTC) atop the market-cap heap. You can even trace Citigroup (NYSE:C) to Sanford Weill's Commercial Credit Company, which you could have owned right through its Travelers days to the $200-plus billion monster it is today.

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? That's precisely the problem with trying to beat the pros with well-known, large caps -- if they're really all that, they're going to cost you. How much? 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. There's a difference. Eventually, names like Target (NYSE:TGT) and Costco (NASDAQ:COST) hit Wall Street's radar hard, but it takes a while. There are dozens of established, profitable companies with lesser-known stocks.

Some of these you've heard of, some you haven't -- yet. Some actually 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 really can
Here's how I know. I stumbled upon Harley-Davidson, the stock, after having seen the bikes for years. At about the same time, I was shocked to learn -- in a hospital of all places -- that a tiny, medical device maker called Guidant was wrestling a monster like Johnson & Johnson 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.

How to start slow if you want
Back in September 2003, I suggested you get the ball rolling with a pair of small-cap ETFs. I'd bought iShares S&P SmallCap 600 Growth Index (AMEX: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 SmallCap 600 Value Index (AMEX:IJS) next -- a promise I thankfully kept.

If you'd bought the growth fund then, you'd be up more than 50%. The value fund has fared even better. I don't bring this up to brag, but to make two points. First, everyone who said 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 small-cap exposure without the risk of taking the plunge on the stocks of individual companies. The strategy of holding the funds, then shifting into Tom Gardner's Hidden Gems at your leisure, strikes me as sound.

At last, the numbers I promised you
According to Ibbotson Associates, since 1926 small-cap stocks have delivered annual returns of 12.6%. That's compared to 10.7% for large caps. At that rate, $5,000 invested in small-cap stocks grows into about $52,000 over the course of 20 years. Imagine if you'd been adding to your position along the way.

And that's overall. In periods when small caps do outperform, they really 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 clear that today's giants sprouted from small-cap gems. So will tomorrow's.

That's Wall-Street's worst-kept secret
Meanwhile, I promised to keep you posted on Hidden Gems' performance. As of January 12, 2006, the 50-plus recommendations are up, on average, 36.7%. That's significantly better than the 13.6% you'd have earned on the S&P 500.

Want to learn more about beating the market with small-cap value stocks? Tom Gardner is offering a special free trial to his Hidden Gems newsletter service. You can take it up directly with Tom and benefit from his complete service for 30 days free. Click here now to learn more.

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

Fool writer Paul Elliott owns none of the stocks mentioned. As always, you can view the entire Hidden Gems scorecard with your 30-day free trial. Costco is a Stock Advisor recommendation. The Motley Fool has a fulldisclosure policy.