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

But that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long run, small stocks outperform their mid- and large-cap peers, 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're serious about this; otherwise, you wouldn't still be reading. And you want an edge to make sure you do better than the average Joe. We all do.

So, why make this difficult? Investors who make the most over the long term buy common stocks. At least they have since Ibbotson Associates started keeping tabs back in 1926. Investors who make even more buy small caps, also according to Ibbotson.

Not quite sure how to get started? Well, the way I see it, you can buy a small-cap fund that keeps its costs in check -- if you can find one. You can buy a decent, low-cost small-cap exchange-traded fund (ETF). Or you can start building a small-cap portfolio of your own.

You're a Fool ... and so am I
Of course, we favor the do-it-yourself approach. Well, sort of. You see, I own my share of small caps, but I also have the occasional cup of joe with Tom Gardner. Tom works 24/7 digging up well-run small companies for his Motley Fool Hidden Gems advisory service -- and he never shuts up about it.

So I've given this some thought. And you know what? I have to admit that Tom's intense focus on value has resulted in a portfolio of small-cap gems I couldn't have built with my focus on story. A portfolio that -- gun to my head -- I would swap straight up for mine. There, I said it.

For all that, Tom and I look for the same things in great small companies. (Maybe he just looks harder?) It's what the all-time great value investors have always looked for. For more detail on this, check out "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.

Look closely. Because as hard as it is to remember now, it wasn't that long ago that these very traits propelled Larry Ellison's Oracle (NASDAQ:ORCL) and Michael Dell's Dell (NASDAQ:DELL) atop the market-capitalization heap. Yes, both started out as small companies with big ideas.

Good work if you can get it
I know what you're thinking: Who in his right mind wouldn't want a portfolio filled with stocks like that? And you're right. That's why you can't beat the pros with heavily followed, large-cap stocks -- if they're really all that, they're going to cost you.

So what's the alternative? Taking a chance on some fly-by-night outfit? Good point. But notice I said heavily followed stocks, not "well-known" companies. See the distinction? Think of household names like Home Depot (NYSE:HD) and Target (NYSE:TGT). The stores have been around forever, but I remember clearly when both were underfollowed stocks.

There's your edge: There are always dozens of established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. Peter Lynch was a master at finding them, earning his Fidelity Magellan fundholders nearly 30% year after year. You can do it, too.

Yes, you can .
Here's how I know. I stumbled upon Harley-Davidson (NYSE:HDI) the stock after having grown up around the bikes (it went on to be 10-bagger in the '90s). When investors starting talking about Electronic Arts (NASDAQ:ERTS), I was already sick of the Madden video game series. By 1995, Abercrombie & Fitch (NYSE:ANF) had already revamped its image to appeal to the mass teen market, but nobody owned the stock.

In fact, it can take a long time 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 can find these stocks and buy them before the big money drives them to the stratosphere (and us along with them).

How to get rolling
Back in September 2003, I suggested you take a look at a pair of small-cap ETFs. I'd bought the iShares S&P 600 Growth Index (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 600 Value Index (IJS), next -- a promise thankfully kept.

Even after the recent small-cap pullback, the growth fund is up a full 90% in a little less than three years. The value fund has fared even better. Clearly, folks who said the small-cap rally was cooked back in September 2003 (and there were many) were wrong. (My hunch is that given the recent volatility, there are even more saying that now -- and that they're still wrong.)

More importantly, these funds trade like stocks and give you quick and dirty small-cap exposure without the stress of taking the plunge on the stocks of individual companies. The strategy of holding the funds, and then shifting into Tom's Hidden Gems when you feel comfortable is rock solid.

Is this small-cap run a fluke?
Not according to Ibbotson Associates, the undisputed king of market data. Since 1926, small-cap stocks have earned 12.4% annually. 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. Now, imagine if you'd been adding to your position along the way.

And that's overall. 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 the small-cap run is over. And even if it is, tomorrow's new leaders will always be today's small caps.

What to do now
In earlier columns, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of July 5, 2006, the recommendations are up, on average, 33.9%. That's compared with 10.7% if you'd invested in the S&P 500 for the same period. As always, you can view every Hidden Gems pick on Tom's live scorecard (available with a free trial).

To learn more about how to use Wall Street's Worst-Kept Secret to beat the market, Tom Gardner is offering a free trial to his complete Hidden Gems service. You can take it up directly with him and sneak a peek at all of his recommendations and back issues. To learn more, simply click here.

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

Fool writer Paul Elliott owns none of the stocks mentioned. Dell and Electronic Arts are Motley Fool Stock Advisor recommendations. Home Depot and Dell are Inside Value picks. The Motley Fool has a fulldisclosure policy.