Hey, buddy, want some personal investment advice? If you own stocks, you should own small caps.

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

I know you're serious about this
You want an edge. We all do. So why make this difficult? Everybody knows that investors who make the most money over the long term buy and hold common stocks.

At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors looking to goose their returns 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 low-cost small-cap fund. We can buy any number of small-cap exchange-traded funds (ETF). Or we can start building a small-cap 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 have the occasional cup of joe with Motley Fool founder Tom Gardner -- a guy who has made a career out of beating Wall Street to the punch on well-run small companies -- and he never shuts up about it.

And you know what? I'm man enough to admit that Tom and his team at Motley Fool Hidden Gems are assembling a stable of small caps I probably couldn't have found on my own. What's the secret? I think it's that Tom focuses on value, while I tend to get wowed by story.

Yet for all our differences, we both look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. For generations, smart investors have 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 many of these same traits gave investors the courage to follow John Morgridge into Cisco Systems (NASDAQ:CSCO) and even Jeff Bezos into Amazon.com (NASDAQ:AMZN). You had to be nimble to get into that last one, but I don't have to tell you how those investments worked out.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like that? And you're right. That's why it's so hard to beat the pros with familiar names like those now -- if they're really all that, they're going to cost you.

But 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 necessarily well-known companies. There's a difference.

For example, big retailers like Costco (NASDAQ:COST) and Home Depot (NYSE:HD) are heavily owned by institutional investors now, but that wasn't always the case. They both had strong regional and even national footprints before they were closely followed on Wall Street.

Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. But if you're expecting a bunch of General Electrics (NYSE:GE), you'll be disappointed. In fact, I'm willing to bet Yahoo! (NASDAQ:YHOO) is the only stock on the list you've ever heard from your broker. Though you might easily recognize the companies from "real life."

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. Peter Lynch was a master at digging up these gems. That's how he earned his Fidelity Magellan fundholders nearly 30% year after year.

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 I thankfully kept.

The growth fund recently hit a new high and has 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, so you can get 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 these funds and scaling into the stocks Tom tells you about each month in his Hidden Gems newsletter is a winner. After all, you want to be diversified, but sooner or later, you want exposure to the small businesses with biggest potential.

Meanwhile, I promise to keep you posted on Hidden Gems performance -- in good times and bad. As of this morning, the recommendations are up, on average, 49.1%. That's compared with 18.1% if you'd invested in the S&P 500 for the same period. That's pretty good.

If you want to learn more, you can take a free trial to the complete Hidden Gems service. That way, you can take it up directly with Tom and check out every current and past recommendation -- plus the latest newsletter issue and all back issues. It's Wall Street's worst-kept secret.

Of course, there's no obligation to subscribe. 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. Amazon.com, Costco, and Yahoo! are Stock Advisor picks. Home Depot is an Inside Value pick. The Motley Fool has a full disclosure policy.