"Small-cap stocks squash large caps like grapes."

That's how I planned to open today. By now, I'd be making my case -- dropping obscure references like Nagel and Quigley and citing 70-plus years' of Ibbotson data.

And by ... now! My inbox would be full. "Your numbers are skewed by a few abnormal years," you'd be hollering, or "What about survivorship bias?" And you're right. That's the fatal flaw with all historical data:

It's just a bunch of numbers, and the future is not the past.

So forget the numbers
You don't need me (or an Excel spreadsheet) to tell you that many of tomorrow's multibillion-dollar corporations are small companies today. It just stands to reason. The trick is distinguishing the winners from the also-rans without the benefit of hindsight.

Can we do it? It's not easy, but I think we can. I'll show you why I say so, but for now, just know that we're going to be looking for smallish companies that are:

  • Run by entrepreneurial zealots with ownership stakes.
  • Free of convoluted relationships with banks.
  • Able to grow their sales and cash flow exponentially.

And there's something else: You want a stock that hasn't hit Wall Street's radar yet. This way, you can benefit from pent-up institutional demand when earnings and revenues pick up, and the sell-side guys finally do catch on.

Now, what do I mean by "zealots"?
How about Apple's (NASDAQ:AAPL) Steve Jobs when he had the audacity to go head to head with Bill Gates' Microsoft (NASDAQ:MSFT) in the 1980s? Without that audacity, Apple might never have lived to see the iPod. Of course, the same could be said of Scott McNealy's Sun Microsystems (NASDAQ:JAVA).

This is nothing new. Decades before, Walt Disney essentially willed a tiny cartoon studio into a global Disney (NYSE:DIS) empire. Talk about nutty -- I mean, zealous. You sense the same passion in Fred Smith, founder of FedEx (NYSE:FDX), whose stock has risen some 20 times in value since 1980.

None of which means that finding these companies is easy, but it can be done. More than anything, we need to be patient, have a plan, and pick our spots. Even better, we can steal a page from Motley Fool co-founder Tom Gardner's Motley Fool Hidden Gems playbook, seeking out companies with market caps of less than $2 billion that offer:

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

Just remember those five keys
Again, they don't come along every day, but they work. I already mentioned McNealy's Sun Microsystems. If you missed Sun Micro, you could have bought into Michael Dell's notion of selling computers direct to consumers, and done even better. Surely, there is another like them lurking out there right now.

But what are your chances of finding the next home run? Probably not as good or as bad as you may think. Earlier, I mentioned Motley Fool co-founder Tom Gardner. Those five keys led Tom and his team of analysts to better-than-225% profits in less than two years, when Shire (NASDAQ:SHPGY) snapped up a drug company called Transkaryotic.

Hidden Gems subscribers locked in another 200%-plus gain when GlaxoSmithKline (NYSE:GSK) took out tiny CNS, makers of the Breathe Right nasal strips. So, you see, it can be done.

Yes, even in this tough market ...
Believe me, it's been a difficult year for me, too. But I hope you haven't given up. If history is any guide, it will be small companies that will lead us out of this recession. That's why I always have a wish list of great small caps on hand. You should, too.

If you're short on ideas, you can try out Hidden Gems free for 30 days. You don't have to subscribe to anything, and you can take a whole month to decide if it works for you. Meanwhile, you can check out the entire portfolio of small-cap value picks and download every back issue right now.

As investors, it doesn't pay to be too proud. We all need an edge and there's comfort in numbers, especially in rocky markets like this one. Be careful, but give up on stocks at your own risk. Are you with me? To learn more about this offer to try Hidden Gems free, simply click here.

This article was originally published on May 10, 2005. It has been updated.

Paul Elliott does not own shares of any company mentioned in this article. You can see the entire Hidden Gems scorecard, including every active and past recommendation, with your free trial. FedEx, Apple, and Disney are Stock Advisor recommendations. Disney is also an Inside Value pick, as is Microsoft. GlaxoSmithKline is an Income Investor choice. The Motley Fool has a disclosure policy.