Hey buddy, want some personal investment advice?

If you own stocks, you should consider small caps. Of course, that's not personal. It's Wall Street's worst-kept secret. Over the long haul, small-company stocks outperform their mid- and large-cap peers.

You're serious about this
Otherwise, you wouldn't still be reading. You want an edge. So why make this tricky? Everybody knows that investors who make the most money 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 small-cap fund that keeps its costs in check. We can buy a low-cost 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 at this for a few years, but I also down the occasional cup of joe with Tom Gardner. Tom has made a career out of beating me to 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 crew at Motley Fool Hidden Gems have led me to a portfolio of small caps I probably wouldn't have found on my own. What's his secret? I think it's that Tom focuses on value, while I love a good story.

Yet for all our differences, we 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:

  • Solid management with significant stakes.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

I know it's hard to imagine, but these traits gave investors the courage to follow Larry Ellison into Oracle (Nasdaq: ORCL) -- a software startup that went on battle ExxonMobil (NYSE: XOM) and General Electric (NYSE: GE) for the top of the market-cap heap. 

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like that? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those now -- 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. Cult favorites Coach (NYSE: COH) and Harley-Davidson, for instance, have long been beloved by consumers, but they've been two of the great stealth stock stories of the past two decades.

Need more? Compare Southwest Airlines with JetBlue (Nasdaq: JBLU). At one time or another, both satisfied most of Tom's criteria. Yet JetBlue was a hot stock right out of the gate. Southwest took years to register a blip on Wall Street's radar. The disparity in their long-term investment returns might make you weep.

Need more proof?
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet Apple is the only one of the 10 you'll ever hear about from your broker. And that's no coincidence. Though you might very easily recognize Green Mountain Coffee Roasters (Nasdaq: GMCR) 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 -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these companies, earning his Fidelity Magellan (FMAGX) 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 iShares S&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, iShares S&P 600 Value Index (IJS), next -- a promise thankfully kept.

Seriously, despite the recent rough patch for smaller stocks, the growth fund is still up 60% since. The value fund has even fared a little better. 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.

Some more personal advice
Why not test the waters with these low-cost funds and then shift gradually into the stocks Tom tells you about each month in his Hidden Gems newsletter? After all, sooner or later, you probably want to be exposed to at least a few small businesses with big potential -- remember those names I mentioned earlier.

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, 28.5%. That's more than twice the 10.1% you have if you'd invested in the S&P 500 for the same period. Not bad, considering how choppy the market's been.

If you want to learn more about how Wall Street's Worst-Kept Secret can help you finally beat the pros, think about this. Tom Gardner's 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, including his top five picks for new money now, and print out every one of his back newsletter issues.

The first month is on Tom and there's no pressure to descibe. Maybe that's Wall Street's best-kept secrect. 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. Of course, you can view all Hidden Gems recommendations instantly with your free trial. The Motley Fool has a full disclosure policy.