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 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
Thus, it stands to reason:

• If investing in small-cap stocks generates market-beating returns, and ...
• If investing in the market's best companies generates market-beating returns, then ...
• 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. It 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 such as Chico's FAS (NYSE:CHS), Deckers Outdoor (NASDAQ:DECK), and Green Mountain Coffee Roasters (NASDAQ:GMCR) long before they emerged from the pack.

Forbes was also early to the party on success stories such as Oceaneering International (NYSE:OII), O'Reilly Automotive (NASDAQ:ORLY), and Pharmaceutical Product Development (NASDAQ:PPDI). Look at the returns:

*Returns through Dec. 30, 2009.

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 Green Mountain Coffee Roasters, there's a company like JAKKS Pacific, which was listed at No. 8 on Forbes' 1999 list.

On the strength of licensing revenue from the Pokemon craze, JAKKS Pacific was one of the hottest non-dot-com stocks of that era. However, when the pace of Pokemon-related revenue slowed (and while it's easy to call it a fad in hindsight, who truly saw that coming?), JAKKS' share price took a nosedive. The stock has rebounded nicely from its 2000 lows, but it's still underwater for anyone who bought in when it first appeared on Forbes' list.

I won't bore you with Forbes' other big misses, but suffice it to say, there have been more than a few. I'm sure Forbes would like to forget the names Build-A-Bear Workshop (NYSE:BBW) and Travelzoo.

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, our team advises investors against searching for winning small-cap investment ideas solely by seeking out the hottest companies of the past 12 months. Instead, the HG team focuses on companies with:

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

Furthermore, the HG team prefers 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.

The Hidden Gems team believes so strongly in its measured approach to small-cap investing that it's working with $250,000 of real money. Find out about the team's latest buy, a dirt-cheap business services company from Forbes’ 2007 list, along with the rest of the team's thoughts on dozens of high-quality small caps, with a risk-free trial.

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

Rich Greifner is happy he made Hidden Gems co-advisor Andy Cross' list of 200 favorite Fools. Rich does not own any of the companies mentioned in this article. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers recommendation. Pharmaceutical Product Development is a Stock Advisor selection. The Fool has a disclosure policy.