The Best Small Companies ... Exposed

It's hardly breaking news at this point, but it bears repeating: Small-cap stocks are your best bet for superior returns. After all, small-cap stocks have trounced their larger brethren over the past 80 years -- and over the past three decades, the competition hasn't even been close:

Data from Ibbotson Associates.

Meanwhile, a recent study by Jeff Anderson and Gary Smith from Pomona College shows that America's most admired companies also have a tendency to beat the market. Anderson and Smith analyzed the returns of Fortune's list of the 10 most admired companies from 1983 to 2004. They found that a portfolio of these stocks outperformed the S&P 500 by "a substantial and statistically significant margin."

By the power of the transitive property
So it stands to reason that if:

A. Investing in small-cap stocks generates market-beating returns; and
B. Investing in the market's best companies generates market-beating returns; then
C. Investing in the market's best small-cap companies should generate market-annihilating returns.

If only there were a list of the best small-cap companies ...
Fortunately, the folks over at Forbes magazine compile an annual list of the 200 best small companies in America. According to Forbes, companies "must pass through a gauntlet to qualify for the list," so you know you're getting the cream of the crop.

To make Forbes' list, a company must have revenue between $5 million and $750 million and a share price higher than $5, and must also clear certain thresholds for returns on equity, sales, and income.

That's some list
As you might expect, Forbes' list boasts some impressive names and more than a few familiar faces. The list successfully identified small-cap stalwarts like Atwood Oceanics (NYSE:ATW), O'Reilly Automotive (NASDAQ:ORLY), and Urban Outfitters (NASDAQ:URBN) long before they emerged from the pack.

Forbes was also early to the party on success stories like Global Industries (NASDAQ:GLBL), FactSet Research Systems (NYSE:FDS), and Pharmaceutical Product Development (NASDAQ:PPDI). Take a look at the returns:

*Returns through June 6, 2008.

But you can only look backward through a screen
Forbes' list does an excellent job of identifying the hottest small-cap companies -- at the moment the list is released. After all, the data Forbes is taking into account is primarily backward-looking.

Clearly, some of these companies continue to excel long after they're featured in the magazine. But for every Urban Outfitters, there's a company like Ceradyne (NASDAQ:CRDN), which ranked 12th on last year's list.

Ceradyne is a leading producer of advanced, lightweight ceramic armor technology for personnel, vehicle, and aircraft applications. Fueled by seemingly insatiable military demand, revenue tripled between fiscal 2004 and 2006, while net income increased four-fold. But due to multiple government delays and extensions, order shipments were pushed back, and the company had to cut both its guidance and its workforce. Ceradyne shares are currently down 46% from when they appeared on Forbes' 2007 list.

I won't bore you with Forbes' other big misses, but suffice it to say there have been more than a few. In fact, all but two of Forbes' top 10 stocks last year are in the red, and four are down by more than 30%!

Don't send a screen to do an investor's job
A stock screen is a great tool for identifying prospective opportunities, but it's no substitute for good old-fashioned due diligence. At Motley Fool Hidden Gems, we advise investors against searching for winning small-cap investment ideas by seeking out the hottest companies of the past 12 months. Instead, we focus on companies with:

• Solid free cash flow;
• Strong balance sheets;
• High insider ownership; and
• Market-beating potential over the next three to five years.

Furthermore, we prefer small companies that are obscured from Wall Street and ignored by the financial media. It's far more profitable to unearth quality companies before they become household names than after they grace the cover of a magazine.

You can look at all of our recommendations by clicking here to try Hidden Gems free for 30 days. We may not have 200 companies on our roster, but we are beating the market by 22 percentage points over the past five years.

This article was first published Dec. 14, 2007. It has been updated.

Rich Greifner is happy he made Bill Mann's list of 200 favorite Fools. Rich does not own any of the companies mentioned in this article. Atwood Oceanics is a Stock Advisor recommendation. The Fool has a disclosure policy.