You're probably well aware that small caps are the clear long-term winner:

Asset Class

Annualized Return From 1926 to 2008

Long-term government bonds


Large-cap stocks


Small-cap stocks


Data from Ibbotson Associates.

The main reason is simple: They're little and have the most room to grow.

Wal-Mart (NYSE:WMT), for example, was able to skyrocket 8,000 times in value since 1970 because it had just a $21.5 million market cap at the time of its IPO.

Another reason for small caps' outperformance is that they're ignored by Wall Street analysts and institutional investors because of their volatility and limited liquidity. At first, large investors may not bother to investigate a promising small company because they're afraid that if they bought the stock, their own buying would drive shares up beyond what they're willing to pay.

But when big market players finally uncover a clear small-cap success story, they quickly bid up shares and make early investors very wealthy.                

Twenty years ago, when Best Buy (NYSE:BBY) was still new to the scene, investors weren't sure whether it could compete with proven companies like Circuit City and Radio Shack.

But those who bought in before it was a proven and highly favored retail concept have been handed more than a 100-fold return.

Winners for now
What you might not know is that small caps are especially winners during market recoveries.

In fact, according to T. Rowe Price, small caps have consistently led the market out of the past 10 recessions, posting an average 28% gain, versus the 19% gain for large caps in the year following the market's recovery.

That 9-point difference might not seem like much, but remember this is an average. In fact, as I've pointed out before, the best stocks emerging from the past recession -- stocks like Research In Motion (NASDAQ:RIMM) and Corning (NYSE:GLW) posted gains of some 2,000% -- a 20-fold return on your investment.

This makes it clear that it's important not just to buy a basket of small caps in a Russell 2000 index fund or ETF, but to make sure you own undervalued small-cap stocks with significant rebound potential.

But don't be fooled -- though many stocks that are down over the past year, not all make solid rebound candidates.

It's best to look for rebound candidates among small-cap companies that have been able to grow revenue with respectable returns on equity. Together, these criteria indicate that a business has staying power -- something you should demand of a small cap.

Here are two examples:


Market Cap

52-Week Return

5-Year Revenue CAGR

Return on Equity (TTM)

Vaalco Energy (NYSE:EGY)

$258 million





$266 million




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

These aren't formal recommendations -- but they are a good starting place for further research.

For those interested ...
I do have a formal recommendation for you, straight from Motley Fool Hidden Gems, our small-cap investing service. The stock is Dynamic Materials (NASDAQ:BOOM), and its specialty is explosive metalworking to produce corrosion-resistant metal. In fact, it's the largest explosion-clad welder in both North America and Europe.

Dynamic Materials boasts a five-year revenue CAGR of 37% and return on equity of 16%. Though its business has slowed somewhat because of the recession, its wide moat and reputation have sustained it -- and when economic activity ticks upward, Dynamic Materials should benefit.

Co-advisors Seth Jayson and Andy Cross are so confident about it they've put real money behind their idea -- and to much success. In fact, the stock is up nearly 100% in the last four months. But don't assume the run-up has come and gone -- they still think the stock has a great deal of potential upside.

I invite you to read their complete analysis of this stock, and to find out what other stocks are currently on their "Buy First" list, completely free. Click here for more information.

Adam J. Wiederman can't wait for Dow 10,000, though he owns none of the stocks above. The Motley Fool owns shares of Dynamic Materials and Best Buy. Dynamic Materials is a Hidden Gems recommendation. Best Buy is a Stock Advisor recommendation. Best Buy and Wal-Mart are Inside Value recommendations. GigaMedia is a Rule Breakers selection. Check out The Motley Fool's strict disclosure policy.