What's Wall Street's worst-kept secret? It's simple.

If you want to make money in stocks, you should look at small caps. It's a point of contention, but I'm convinced that, over the long haul, small-company stocks outperform mid and large caps.

You want an edge
Otherwise, you wouldn't be reading this. So, why make this more difficult than it has to be? Despite recent arguments to the contrary, spawned by the so-called lost decade, investors who make the most money over the long term don't hold cash or buy bonds, or even gold.

They buy and hold common stocks. At least, they have since Ibbotson Associates started keeping tabs back in 1926. Investors who have wanted to make even more have at least dabbled in small caps, also according to Ibbotson.

Assuming that's true -- and that we still have the guts to buy and hold for the long term -- we have a few choices. We can take a chance on a small-cap fund that keeps its costs in check. We can buy a low-cost exchange-traded fund (ETF). Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I have the good fortune to enjoy the occasional chat with Tom Gardner. Tom, as you may already know, co-founded The Motley Fool with his brother David back in 1993. He has also made a career out of beating the Wall Street pros to well-run small companies.

And I'm man enough to admit that the team of analysts Tom has assembled at Motley Fool Hidden Gems is building a portfolio of small-cap stocks that I probably wouldn't have found on my own. What's their secret? I think it's that Tom's guys focus on value, while I have always loved a good story.

Yet for all our differences in approach, we do look for the same things in great small companies. Then again, it's not like it's a system either one of us invented. A long line of smart investors have beaten the market by looking for:

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

I know it's hard to imagine now, but these traits gave early investors the courage to follow Larry Ellison into Oracle (Nasdaq: ORCL) -- a one-time software start-up that in the late '90s went on to battle Pfizer (NYSE: PFE) and General Electric (NYSE: GE) for the top of the market-cap heap.

Good work if you can get it
I know what you're thinking: Who wouldn't want a portfolio filled with stocks like Oracle (or even GE)? At least in their prime. And you're right. That's why you'll rarely beat the pros with familiar names like those are now -- if they're really all that, they're going to cost you.

So, what are you going to do? Take a chance on some fly by-night outfit? Good point. But notice I said well-known stocks -- not companies. There's a difference. Harley-Davidson (NYSE: HOG), for instance, had a cult following for years, but it was one of the great stealth stock stories of the 1990s. Ditto for Coach (NYSE: COH) -- a stock I own myself -- after being spun off from Sara Lee (NYSE: SLE) at the beginning of this decade.

Or compare Southwest Airlines with JetBlue (Nasdaq: JBLU). Neither fits the mold now, but at one time or another, both satisfied most of Tom's Hidden Gems criteria. Yet JetBlue, you'll recall, was a hot stock out of the gate. Southwest was a cult favorite and took years to register a blip on Wall Street's radar. Which would you rather own now?

Here's one more idea
Check out Tim Hanson's list of the best-performing stocks of the past 10 years. I'm willing to bet you won't hear many of those names from your broker. And that's no coincidence -- though you might very easily recognize Green Mountain Coffee Roasters from "real life."

Put it altogether and you see our edge: We can always find established, profitable companies with unknown stocks. Some you've heard of; some you may not have -- yet. Some even dominate their markets. The legendary Peter Lynch was a master at finding these companies, earning his Fidelity Magellan (FMAGX) fundholders nearly 30% per year on average.

Here's some more personal advice
Go ahead and test the waters with a low-cost fund like iShares S&P 600 Small-Cap Value Index (IJS) and then shift gradually into the stocks that Tom Gardner's guys tell you about each month in his Hidden Gems newsletter. Sooner or later, you want to be exposed to at least a few small businesses with big potential -- remember those names I mentioned earlier.

Even better, if you want to learn more about how Wall Street's worst-kept secret can help you beat the pros, think about this: You can take a free trial to the complete Hidden Gems service right now. You can view all the picks immediately and look on as the team invests in a real money portfolio (already two of their holdings have doubled since they launched the portfolio in March 2009).

You can even read and print out every one of his back newsletter issues, if you like. Best of all, the first month is on me, and there's never any pressure to subscribe, no matter how much you've used the service. I've been saying I haven't seen a market this suited to small caps since 2003. I bought it then, and I'm buying now. To learn more about trying Hidden Gems for free, simply click here.

This article was originally published on Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P 600 Growth Index, the iShares S&P 600 Value Index, Pfizer, and Coach. Coach is a Stock Advisor recommendation. Green Mountain Coffee Roasters is a Rule Breakers pick. Pfizer is an Inside Value pick. You can view the entire Motley Fool Hidden Gems scorecard with your free trial. The Motley Fool has a full disclosure policy.