Some investors can be so predictable. When the stock market is going up, they take risks. These folks buy speculative companies in the hopes of striking it rich -- sending valuations far and above what fundamentals would otherwise justify.

That's what happened for much of 2004, 2005, and 2006 -- a period when the U.S. markets enjoyed a vacation of unprecedented placidness. As a result, investors bought more risk -- and small companies absolutely dusted their larger peers.

Suddenly, this summer, everything changed.

Hey, who invited the bear?
For whatever reason, the market chose May 2006 to finally get spooked by a confluence of foreboding economic factors: rising interest rates and energy prices, instability in the Middle East, and a weakening dollar and deepening trade deficits. Why May? Who knows? It's difficult to predict when our collective sobering up will occur.

It is, however, not so difficult to predict what will happen when our collective sobering up occurs: People panic and sell. Thus, those same speculative companies that folks were willing to buy during placid times start getting downright hammered. Just take a look.

Company

Market Cap

Price Change,
1/04 to 4/06

Price Change,
5/06 to 10/06

BTU International (NASDAQ:BTUI)

$89

484%

(52%)

California Coastal Communities (NASDAQ:CALC)

$181

233%

(46%)

Cosi (NASDAQ:COSI)

$170

244%

(55%)

Rocky Mountain Chocolate Factory (NASDAQ:RMCF)

$81

178%

(15%)

Stamps.com (NASDAQ:STMP)

$376

143%

(47%)

Source: Capital IQ, a division of Standard & Poor's. Dollars in millions.

All of these are fairly speculative companies, and they're as speculative today, for the most part, as they were when investors were buying shares of them left and right. Of course, large caps haven't been spared, either. Both Corning (NYSE:GLW) and SanDisk (NASDAQ:SNDK) are down more than 20% since May.

So what's changed? Simply put: Investors panicked. They moved their assets looking for something -- anything -- to protect them from volatility.

What do we know we know?
But you don't make a killing in the market by panicking along with everyone else. In fact, you can make a killing by acting contrary to the market. (And being contrarian with small caps can be particularly rewarding.)

Volatility is a fact of small-cap investing. That's why we advise members of our Motley Fool Hidden Gems small-cap investing service to maintain broad diversification. Fool co-founder Tom Gardner, for example, recommends that members hold upward of 40 to 50 stocks at any one time. Yes, some of these stocks will go down. Some may even go to zero. But at Hidden Gems, we don't recommend the same kind of speculative plays that are popular during the market's good times.

Instead, we search out our recommendations using bottom-up fundamental analysis.

The keys to small-cap contrarianism
Here's what we look for:

  1. Committed, shareholder-friendly management, and ...
  2. A wide market opportunity, or ...
  3. A deep mispricing.

We use a number of quantitative ratios and qualitative data points to make our recommendations, but that simple three-step formula has helped our recommendations beat the market by 20 percentage points since 2003. And if you've been following the market since May, then you know that the recent volatility has made for more mispricings and, therefore, more small-cap opportunities.

Ready to strike?
Now you know why the market stumbles and how you can take advantage. If you'd like to learn more about our recommendations or try our Hidden Gems service free for 30 days, just click here. There is no obligation to subscribe.

This article was originally published on Aug. 28, 2006. It has been updated.

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