If you own stocks, you should own small caps.

Of course, that's not personal investment advice. That's Wall Street's worst-kept secret: Over the long haul, small-company stocks outperform their mid- and large-cap peers.

I think you're serious about this
Otherwise, you wouldn't still be reading. And we all want an edge. So, why make this difficult? Everybody knows that 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.

The way I see it, we have a few choices. We can take a chance on a 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 portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I've been a small-cap guy for years, but I also have the occasional cup of joe with Tom Gardner. If you don't know Tom, he finds well-run small companies for his subscribers at Motley Fool Hidden Gems -- and he never shuts up about it.

And you know what? I'm man enough to admit that Tom is building a stable of small caps I probably couldn't build on my own. What's his secret? I think it's that he focuses on value, while I tend to get wowed by story.

Yet for all our differences, Tom and I do look for the same things in great small companies. Then again, 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.

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? And you're right. That's precisely the problem with trying to beat the pros with well-known, large-cap stocks -- if they're really all that, they're going to cost you.

So what are you going to do? Take a chance on some fly-by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference. After all, I knew the ticker symbol for eBay (NASDAQ:EBAY) long before I auctioned off my Motley Fool golf bag (oops). Google (NASDAQ:GOOG), by contrast, was a verb before you could buy a single share.

Yahoo! (NASDAQ:YHOO), curiously, seemed to hit Main Street and Wall Street at precisely the same instant. Yet, all three were crawling with Wall Street analysts before you or I could get an edge. But what about familar consumer dynamos such as Abercrombie & Fitch (NYSE:ANF)? More than 20 analysts cover the company now. But you had shopped it for years before you even thought to buy the stock.

And those are just two recent examples. There's always a new crop of established, profitable companies with lesser-known, underfollowed stocks. Peter Lynch was a master at finding these stealth bombers. Remember, it wasn't flashy tech, but mostly unassuming retailers like Gap (NYSE:GPS) that earned Lynch's Fidelity Magellan fundholders nearly 30% year after year. With a little work, you can do it, too.

Need proof?
Tim Hanson recently tracked down the best-performing stocks of the past 10 years. Check them out. But don't expect to find story stocks and Wall Street regulars on the list. Instead, look for solid franchises and underfollowed stocks like Celgene (NASDAQ:CELG), a mid-tier pharmaceutical company with a line of proven drugs, which climbed more than 4,800% over 10 years.

But wait, that's good news. That means 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.

How to get rolling
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 last summer's small-cap pullback, the growth fund has nearly doubled in three years. The value fund has fared even better. Apparently, folks who pronounced the small-cap rally dead back in September 2003 were wrong. (My hunch is that 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 strategy of holding either one of these funds and then shifting gradually into the stocks Tom recommends in Hidden Gems is solid. But sooner or later, you probably want to be exposed to at least a few small businesses with big potential. That's where the fun is.

Meanwhile, I promised to keep you posted on Hidden Gems' performance -- in good times and bad. As of this morning, the recommendations are up, on average, 45.3%. That's compared with 20.3% if you'd invested in the S&P 500 for the same period. Not bad.

If you'd like to learn more about how Wall Street's worst-kept secret can help you beat the market, 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 every one of his back issues. To learn more, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

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, Yahoo!, and Gap are Stock Advisor picks. Gap is also an Inside Value pick. The Motley Fool has a fulldisclosure policy.