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

Wait a minute. That's not personal investment advice. That's Wall Street's worst-kept secret: Over the long run, small-company stocks outperform their mid- and large-cap peers, so smart investors own them. Period.

It's only what you need
I know you're serious about this; otherwise, you wouldn't still be reading. And you want an edge. 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.

So, the way I see it, we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost small-cap exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Of course, we favor the do-it-yourself approach. Well, sort of. You see, I'm a small-cap investor myself, but I also have the occasional cup of joe with Tom Gardner, who digs up well-run small companies for his subscribers at Motley Fool Hidden Gems -- and he never shuts up about it.

And you know what? I can admit that Tom is putting together a decent portfolio of small caps I probably wouldn't have built on my own. What's his advantage? I think it's that Tom focuses on value, while I tend to focus a bit too much on story.

Yet for all our differences, Tom and I do look for the same things in great small companies. (Maybe he just looks harder?) After all, it's not like it's a system either one of us invented. Smart investors have always looked for...

  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.

I know it's hard to imagine, but these same traits gave early investors the courage to buy into John Chambers' vision for Cisco (NASDAQ:CSCO) in the early '90s and to follow Andy Grove into Intel (NASDAQ:INTC). I don't have to tell you that both were blowout investments.

Good work if you can get it
I know what you're thinking: Who in his or her right mind wouldn't want a portfolio filled with stocks like that -- at least when the companies are on the rise? And you're right. That's why it's so hard to beat the pros with those same stocks today -- if they're really all that now, everybody knows it.

So what's the alternative? Taking a chance on some fly-by-night outfit? Good point. But notice we're talking about heavily followed, large-cap stocks, not "well-known" companies. To see the distinction, here's another example from Tom Gardner.

Back in August 2003, one of Tom's analysts recommended CNS (NASDAQ:CNXS), the guys who make the Breathe Right nasal strips that football players made famous. I discussed the company myself in February 2004. The stock was a winner -- even before drug giant GlaxoSmithKline (NYSE:GSK) swept in with a 30% premium buyout offer this morning.

All told, CNS is up more than 230% for Hidden Gems members. (You can view the complete results with a free trial. More below.) But like many great Wall Street success stories, the company's products were well known on Main Street. The stock, however, was underfollowed -- and there's your advantage.

Need more proof?
Tim Hanson recently put together a list of the best-performing stocks of the past 10 years. Check them out if you've got a minute. But don't expect to find eBay (NASDAQ:EBAY) or even Apple (NASDAQ:AAPL) on the list. Those are widely held stocks. Instead, you'll find strong emerging small businesses like drug developer Celgene (NASDAQ:CELG), which climbed more than 6,500% in 10 years.

You see, there's your edge: You can always find 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 these stocks, earning his Fidelity Magellan fundholders nearly 30% year after year.

How to get rolling
Way back in September 2003, I suggested you take a look at a pair of small-cap ETFs. I'd bought the iSharesS&P 600 Growth Index (IJT) at about $65 earlier in the year and was thrilled with my returns. I pledged to buy the sister fund, iSharesS&P 600 Value Index (IJS), next -- a promise thankfully kept.

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

More importantly, these funds trade like stocks, giving you quick and dirty small-cap exposure without the stress of taking the plunge on the stocks of individual companies.

What to do now
If you ask me, a simple strategy of holding either one of these funds and then shifting gradually into the stocks Tom recommends in Hidden Gems is rock solid. But sooner or later, you probably want to be exposed to at least a few small businesses with huge potential. That's certainly where the fun is.

Meanwhile, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of Oct. 9, 2006, the recommendations are up, on average, 34.4%. That's compared with 15.9% if you'd invested in the S&P 500 for the same period.

To learn more about how to use Wall Street's worst-kept secret to beat the market, you should know that 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 shares of the iShares S&P 600 Growth Index and the iShares S&P 600 Value Index, but no other securities mentioned in this article. eBay is a Motley Fool Stock Advisor recommendation. Intel is an Inside Value pick. GlaxoSmithKline is an Income Investor selection. The Motley Fool has a fulldisclosure policy.