This is the year of the small cap -- at least in terms of my writing schedule, anyway. I've reached three conclusions thus far:

  1. Small caps offer the potential for huge returns.
  2. Management matters.
  3. Cash and debt matter not, as long as the debt can be serviced.

So far, so good.

There's more
Then I found myself reading Forbes, and I came across an article about B. Randolph Bateman's Huntington Situs Small-Cap mutual fund. Bateman picks small caps, as the name of his fund would indicate, but he has an interesting methodology.

He picks small caps based on geography.

Small-cap real estate
The hypothesis goes something like this: Because small caps are small, their operations are sensitive to external factors. One of these factors is the relative business friendliness of the location in which the small cap operates. Therefore, small caps that do business in business-friendly states such as Florida and Texas are more likely to succeed.

I see you nodding along like I was. The question, of course: Is it working?

So far, yes, it is. Situs has delivered 18% annualized returns since its 2002 inception. Can this performance continue? That obviously depends on the stocks Bateman is picking. Here are the fund's current top 10 holdings.

Company

Primary Office Location

Jacobs Engineering
(NYSE:JEC)

Pasadena, Calif.

Armor Holdings
(NYSE:AH)

Jacksonville, Fla.

Mentor
(NYSE:MNT)

Santa Barbara, Calif.

Cullen/Frost Bankers

San Antonio, Texas

Transaction Systems Architects
(NASDAQ:TSAI)

Omaha, Neb.

Universal Forest Products

Grand Rapids, Mich.

Denbury Resources
(NYSE:DNR)

Plano, Texas

Global Imaging Systems (NASDAQ:GISX)

Tampa, Fla.

Edwards Lifesciences

Irvine, Calif.

Precision Castparts
(NYSE:PCP)

Portland, Ore.


Method to the madness?
Now, I don't think of Michigan as a particularly business-friendly state, and I think it's obvious that Bateman is not picking businesses based on geography alone. Many of these companies do business a ways away from their primary office locations.

Moreover, as Thomas Friedman wrote in The World Is Flat, it's becoming easier and easier for small companies to act big. In other words, primary office location can now be irrelevant to operations.

I'm interested to see whether Bateman's outperformance continues. In all honesty, I don't think the geography investment strategy -- if it is just geography alone -- will hold up over the long run.

The Foolish bottom line
I do, however, agree that small details can have huge effects on small companies. That's why when we look for superior small caps at Motley Fool Hidden Gems, we seek these five traits:

  1. Devoted leadership.
  2. A sound balance sheet.
  3. Early dividend payments.
  4. A wide market opportunity.
  5. A broken stock price.

By finding companies that meet all these criteria, we put the odds of finding a small-cap winner firmly in our favor. And like I said before, the returns can be huge. Our recommendations have returned 31% on average to data, beating the S&P 500 by nearly 17 percentage points.

If you'd like to learn more about our small-cap methodology and Hidden Gems service, click here.

This article was originally published on March 17, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned in this article. No Fool is too cool for disclosure.