My colleague Tim Hanson and I have written about the benefits of making small-cap stocks a part of your portfolio. In "The Market's 10 Best Stocks," Tim explained that the best-performing companies over the past 10 years all started the decade with a market cap of less than $200 million.

I followed that up with an explanation of the greater risk these tiny companies carry and how to reduce the chance of having them put a big dent in your portfolio.

Today, I'll explain how in the heck you find these companies in the first place.

The evidence
Aswath Damodaran is a professor of finance at NYU's Stern School of Business, and he's one of the sharpest minds in his field. In his book Investment Fables, he notes that small-cap stocks have, on average, outperformed large caps over the very long term and that the greatest outperformance comes from micro caps valued under $250 million. What's more, there's also evidence that returns tend to increase as the number of analysts following a stock decreases.

The execution
This makes sense, and it's exactly what we look for in Motley Fool Hidden Gems: small, obscure, undervalued companies with little or no following. It's what's led to 26% total average returns over the past three years, when equal investments in the S&P 500 would have returned 9%.

To give us a good starting place in the hunt for the market's next batch of great returns, I started with my Modified Foolish 8 screen, which has returned a total of 749% since 1998, according to the American Association of Individual Investors (AAII). The screen passes only high-growth companies with strong insider ownership and reasonable price-to-growth ratios. To that, I made one simple change, keeping only companies with a market cap of $250 million or less. Only five passed the screen (and remember, these companies carry a whole lotta risk, and your own proper due diligence is required):

Company

Market Cap
(millions)

Fuel Tech (FTEK)

$232.5

Bodisen Biotech (AMEX:BBC)

$219

Warrior Energy Service (WARR)

$198.2

U.S. Global Investors (GROW)

$137.3

RELM Wireless (RWC)

$94.1



Of particular interest is Fuel Tech, which was singled out as a Tiny Gem in the January 2006 issue of Hidden Gems and has since returned 24%. It makes chemicals that reduce levels of pollution caused by nitrogen oxide emissions from boilers, flues, incinerators, and furnaces. The Hidden Gems team sees the pollution-control business exploding in the years to come.

Looking larger
Feel like considering some larger companies with similar characteristics? I altered the original Foolish-8 screen (another good performer, according to AAII) to remove the volume and relative strength requirements and came up with some interesting stocks that have strong sales and earnings growth, high margins, and high insider ownership. Here are just a few:

Company

Market cap
(millions)

Google (NASDAQ:GOOG)

$118,236.1

Seagate Technology (NYSE:STX)

$13,436.6

Garmin (NASDAQ:GRMN)

$10,339

First Marblehead (NYSE:FMD)

$3,036.8

Affiliated Managers Group (NYSE:AMG)

$2,666.5

Hansen Natural (HANS)

$3,921.4

Netflix (NASDAQ:NFLX)

$1,370.9



Some of these names may be familiar to Hidden Gems members, as well as to subscribers to our other newsletters.

Foolish bottom line
These two lists should give you some leads in your search for great stocks. Small, obscure, lightly followed -- these are all good things. And with the exception of Google, even the larger-company list is not exactly known far and wide.

You can also join us to see which small caps we've officially recommended in Hidden Gems. Tom is currently offering a 30-day free trial, no strings attached.

Rex Moore currently owns no companies mentioned in this story but is considering a couple of them. Garmin and Netflix are Stock Advisor recommendations. First Marblehead is a Hidden Gems recommendation. The Motley Fool has a disclosure policy.