If you invest in stocks, you must own small caps.

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

It's only what you need
I'll back that up with some data, but first, let's talk about you. You are serious about this; otherwise, you wouldn't still be reading. You want an edge -- a secret -- that will help you make more money over the long haul. So do I.

So why make this harder than it needs to be? Investors who make the most over the long term hold stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. Investors who make the most hold small stocks -- at least they have so far, also according to Ibbotson.

As I see it, you have a choice. You can buy a proven small-cap fund that keeps its costs in check. You can buy a small-cap exchange-traded fund (ETF). Or you can seek out the very best small companies and build a great small-cap portfolio of your own.

You're a Fool ...
... and so am I. So you'd think we'd favor the do-it-yourself approach. Well, sort of. I've found my fair share of small caps. But I also have the occasional cup of joe with Tom Gardner, who digs up small caps for his Motley Fool Hidden Gems small-cap advisory service -- and he never shuts up about it.

And you know what? For better or worse, Tom's more disciplined value approach has built a portfolio of small caps I couldn't have found 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 many of the same things in a great small company. It's what successful 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:

  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.

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

So what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference. For instance, I knew the ticker symbol for eBay (NASDAQ:EBAY) long before I auctioned off my Fool golf bag (oops). Yahoo! (NASDAQ:YHOO), curiously, seemed to hit Main Street and Wall Street at precisely the same instant.

Google (NASDAQ:GOOG), by contrast, was a verb before you could buy a single share. Yet, all three were crawling with Wall Street analysts before you or I could get an edge. But not so consumer dynamos such as Best Buy (NYSE:BBY). Lots of analysts cover it now. But you shopped its stores for years before you even thought to buy the stock.

That's why there is always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Some of these you will have heard of; some you may not have -- yet. Some actually dominate their markets. Peter Lynch was a master at finding these stealth bombers, which is how he earned his Fidelity Magellan fundholders nearly 30% year after year. With a little work, you can do it, too.

Yes, you can -- here's how I know
By the time I stumbled upon Harley-Davidsonthe stock, Harley the bikes were a part of American history. Similarly, analysts are endlessly banging the table on the retailers, but former small-cap rockets like American Eagle (NASDAQ:AEOS) and especially Chico's (NYSE:CHS) were right there at the mall for all of us to see (and buy) long before Wall Street discovered them.

Of course, that's precisely how Lynch made a fortune on Gap (NYSE:GPS) a decade before. My point is, it can take years for a stock to cross the big boys' radar. And when it does, it usually hogs the radar screen long after it should have blipped off. That gives us a great advantage as small investors. We can find these Wall Street darlings and buy them before the big money drives them to the stratosphere.

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

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 this small-cap run is over. Either way, it's a fact: 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
In previous columns, I promised to keep you posted on Hidden Gems performance. As of June 1, 2006, the recommendations were up, on average, 37%. That's compared with 11.6% if you'd invested in the S&P 500. How does he do it?

You can learn all about Tom Gardner's approach to beating the market with small-cap value the easy way. Tom is offering a special free trial to his Motley Fool Hidden Gems service. You can take it up directly with him online and even sneak a peek at all of his back issues and picks. Simply click here to check it out.

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

Fool writer Paul Elliott does not own shares of any company mentioned. Gap, eBay, and Best Buy are Motley Fool Stock Advisor recommendations. You can check out all of Tom's picks with your free trial -- right on the Hidden Gems scorecard. The Motley Fool has a fulldisclosure policy.