7 Small-Cap Stocks the Pros Love

When it comes to picking stocks that have the most potential for explosive growth, you can't beat small-cap stocks. But finding tomorrow's best small caps before the rest of the investing world piles in can be tricky. By taking a look at what some of the world's best professional investors are doing, you can get some great ideas to add to your own portfolio.

The small investor's dilemma
Most investors stick with well-known large-cap stocks when they first start investing. After all, big companies that you're already familiar with make it easier for you to get a comfort level about their businesses and prospects. Moreover, because everyone knows about those companies, you'll constantly hear about them from major news sources.

In contrast, investing in small-cap stocks is a lot harder. When you first start doing research on smaller companies, you'll run into lots of names you've never heard before. Getting reliable information about them can be difficult, and you certainly won't run into them regularly from typical sources. To get a strong handle on a small-cap, you really have to do your own homework -- and you have to commit to taking on that added workload for as long as you own the stock.

Borrowing from the pros
Fortunately, there's a shortcut you can take that will at least uncover some promising ideas for you to look into further. Because professional investors are required to report their holdings on a regular basis, you can basically crib off their work to see which stocks they think are most likely to perform well.

Of course, poring through hundreds of fund filings at the SEC is a lot of work. But with the help of a new service called AlphaClone, you can learn a lot about how hedge funds, mutual funds, and other institutional investors are investing their money.

For instance, when I looked for which small-cap stocks were the best ideas among professional investors, I came up the following stocks, among others:

Sources: AlphaClone, Yahoo! Finance.

These stocks all have an interesting pedigree and show the diversity of the small-cap space. American Capital, Radian Group, and MGIC all serve niche financial industries, with Radian and MGIC providing private mortgage-related insurance while American Capital offers mezzanine-level financing to start-up companies. Each has seen share prices suffer since before the financial crisis in 2008.

Innovation is a key for most companies of this size. JA Solar is a major player in solar energy and has recently announced major new orders from a number of customers. Sonus Networks helps provide voice services over the Internet. In the health-care industry, Allscripts-Misys helps facilitate the exchange of medical information across all interested parties, from doctors and hospitals to health insurance companies and billing services.

Too late?
The problem with these stocks, though, is that many of them already seen a big run-up since the funds reported their holdings as of June 30. Just because some smart pros bought JA Solar in advance of a move of nearly 80% doesn't mean that it's still a good buy at a much higher price. Among these stocks, only Nutrisystem has seen a decline, likely because of heightened competition in the weight-loss space.

However, one thing to remember about small-cap stocks is that they have the ability to make multibagger moves in a short period of time. Even if you're not first in, you can still often pick up big profits from buying shares relatively early in a stock's growth phase.

If small-caps seem intimidating to you, you're not alone. But with a little help from the pros, you can narrow down the thousands of small-cap stocks to a manageable list for further research. Although not all of the pros' picks will make sense for you, you may well find one or two that could bring you the gains you've always dreamed of.

With small caps, buying the wrong stock in the wrong industry can kill you. Rick Munarriz looks at three sectors you should avoid.