The 10 best-performing stocks from 1996 through 2005 were obscure, ignored, and small. But what about the top 25? The top 50? The top 100?

It turns out that most of the stock market's greatest performers of that decade were also obscure, ignored, and small.

Small stocks for big returns
There were 325 stocks that could have earned you greater than 20% annualized returns over those 10 years -- turning a $10,000 initial investment into more than $60,000. Of those 325 stocks, 296 of them were small caps. That's more than 90%. While the companies run the gamut from high-tech players like semiconductor maker Semtech (NASDAQ:SMTC) to low-tech (in a good way) mobile-home parts maker Drew Industries, the common thread is size.

Ten years ago, Semtech was a microcap. Today, it's a nearly billion-dollar company that counts giants such as Cisco Systems (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), and Motorola (NYSE:MOT) as customers. Drew Industries grew from its $100 million valuation to $700 million (now $600 million), rewarding shareholders along the way.

And Drew Industries, for one, is still growing. The company dominates its niche and has almost every trait investors should look for in a small cap: superior leadership, clear competitive advantages, a strong corporate culture, and superior returns on equity (greater than 20% over the trailing 12 months). Since we recommended it in our Motley Fool Hidden Gems newsletter in April 2005, it's also returned nearly 50% for our members, and we're confident that will keep on performing over the long term.

Big stocks for smaller returns
Only 29 mid- or large-cap companies would have given you the same growth, and they're the cream of the crop: Bed Bath & Beyond (NASDAQ:BBBY) and Lowe's, to name two. And while the returns have been incredible from these companies -- both of which demonstrate some key traits of great small caps, including strong brands, strong competitive positions, and strong leadership -- there are just as many from the small guys.

That's because it's difficult for larger companies to generate the same kind of growth as small caps. During the 10 years preceding 2005, Drew Industries grew from $100 million to $700 million. Lowe's, on the other hand, grew from a $7.1 billion valuation to $49 billion. While Lowe's added substantially more value in absolute terms, the story changes when it comes to percentages. Drew increased more than 600%; Lowe's increased 595%. Now compare that with a much larger company such as IBM (NYSE:IBM). Big Blue added $80 billion in value during the same 10-year span. Yet that increase resulted in just 280% gains for investors. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.

The Foolish conclusion
Small caps are one area of the market in which the individual investor has the opportunity to earn phenomenal returns, but there are also pitfalls. For every one of the 296 small caps that could have earned you greater than 20% annualized returns over the past 10 years, quite a few more didn't make it. Small-cap stocks tend to carry considerably more risk than large caps, so investors must consider their investments very carefully.

That's why we advocate a diversified portfolio of select small caps for Hidden Gems subscribers. By focusing on factors such as superior management and a strong balance sheet and enjoying the benefits of diversification, our small-cap recommendations have outperformed the market by more than 25 percentage points since we started.

Every investor should have at least some smart exposure to small caps, because the historical profits are just too good to pass up. If you'd like some help getting started in this incredible area of the market, click here to join our community free for 30 days.

This article was originally published on Feb. 6, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Bed Bath & Beyond is a Stock Advisor and Inside Value pick. No Fool is too cool fordisclosure.