Investors have a natural attraction to large-cap stocks, and that's understandable. Everyone's heard of Cisco Systems and Coca-Cola, after all, and most know what they do to generate revenue. There's also a lot of analyst and news coverage for large caps, so we all have a good way of knowing what these firms are up to. Sounds like a great deal, right?

Well, it is -- if you want to settle for lower returns.

Why you need small caps
According to research from NYU professor Aswath Damodaran, studies have consistently found that smaller firms "earn higher returns than larger firms of equivalent risk." During Damodaran's study period of 1927 to 2001, the smallest companies outperformed the largest ones with a 20% annual return versus 12% on a value-weighted basis. The outperformance was even greater on an equally weighted basis.

One reason is that small caps -- being, um, small -- simply have more "room to run" than the big boys. You can get a better sense of this by looking at the top-performing large- and small-cap stocks over the past five years. First, a sampling of some of the top 20 companies with a market cap of more than $50 billion 10 years ago:

Company

Dec 2003 Market Cap
(in billions)

Total Return (Dec 2003
to Dec 2008)

ExxonMobil

$181

109%

Chevron

$55

70%

McDonald's (NYSE:MCD)

$53

54%

Eni SpA

$52

47%

Wal-Mart (NYSE:WMT)

$180

37%

HSBC (NYSE:HBC)

$68

25%

Now, here were some of the best performers for companies with a market cap between $200 million and $2.5 billion (the universe we search to make recommendations for in our Motley Fool Hidden Gems small-cap investing service):

Company

Dec 2003 Market Cap
(in millions)

Total Return (Dec 2003
to Dec 2008)

Celgene (NASDAQ:CELG)

$242

4,170%

XTO Energy (NYSE:XTO)

$286

3,400%

Gilead Sciences (NASDAQ:GILD)

$1,179

1,967%

Flir Systems

$263

925%

LAN Airlines

$1,381

881%

Marvel Entertainment (NYSE:MVL)

$209

622%

Data provided by Capital IQ, a division of Standard & Poor's.

Simply put, the smallest companies have much more upside than the largest. But be aware: Higher potential reward comes with higher risk. Buy one of the worst-performing small caps, and you'll likely earn a total loss of capital -- which is a fancy Wall Street phrase for "losing all your money." That's why, at Hidden Gems, we seek out only the highest-quality small caps: those with high insider ownership, a strong balance sheet, a solid business model, and compelling valuation.

It's time to think small
Using these principles, the Hidden Gems team's stock recommendations have outperformed the S&P 500 by an average of seven percentage points since the service began more than five years ago. This shows that small caps can indeed improve returns, and they should be a part of any balanced portfolio.

If you're interested in a look at all of the Hidden Gems recommendations, the team is offering a full-access, 30-day free trial to the service -- which includes the top five small caps to buy right now. Here's more information.

This article was originally published on Sept. 14, 2006. It has been updated.

Rex Moore has nearly mastered quantum mechanics, but is stuck on that "wave-particle duality" thingie. He owns no companies mentioned in this story. Wal-Mart and Coca-Cola are Motley Fool Inside Value recommendations. Marvel Entertainment is a Stock Advisor selection. LAN Airlines is an Income Investor choice. The Fool's disclosure policy shines year-round.