"Over the years, small-cap stocks crush their large- and mid-cap peers."

That's how I planned to start today. By now, I'd be making my case -- dropping obscure names like Nagel and Quigley and banging the table on 70 years' worth 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, of course, you'd be right. It's the one fatal flaw with all historical data: The future is not the past.

So forget the numbers
Fortunately, you don't need Excel to tell you that many of tomorrow's industry leaders are up-and-coming small companies today. It just stands to reason. What you need is a system to help you find them before they become household names. If history is any guide, we're looking for a smallish company ...

  1. Run by entrepreneurial zealots with ownership stakes.
  2. Free of convoluted relationships with investment banks.
  3. Able to grow its sales and cash flow exponentially.

And one more thing: You're looking for a stock that hasn't hit Wall Street's radar yet, so you can benefit from pent-up demand when earnings and revenues pick up, and the sell-side analysts finally catch on.

But what do I mean, "zealots?"
How about David Filo and Jerry Yang? If you don't recognize their names, I bet you know their company, Yahoo! (NASDAQ:YHOO). And then there's Jeff Bezos, whose name you do recognize. His work at Amazon.com (NASDAQ:AMZN) made him Time's Person of the Year, for Pete's sake.

You don't need to check these guys' SEC filings to know they have huge stakes in their businesses -- or see a stock chart to know they made early investors a ton of money. Moreover, there's one born every day. That's the beauty of the stock market, after all. Even if we're not geniuses, it lets us hitch our wagons to those who are.

Which is not to say that finding these guys is easy, but it can be done. More than anything, we need to be patient and pick our spots. Even better, we can take a cue from the Motley Fool Hidden Gems method and seek out companies with market caps of less than $2 billion that offer:

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

Just remember those five keys
Again, they don't come along every day, but they really work. I was shocked to see that unassuming Lowe's (NYSE:LOW) is up more than 25 times since 1990. Starbucks (NASDAQ:SBUX), a Motley Fool favorite since the mid-'90s, made a killing for early investors. Two in a million, you say? Maybe not.

Love him or hate him, much the same happened with Rupert Murdoch's News Corp. (NYSE:NWS). And you don't have to be a media hound to get in on the action. Techies could have followed security mastermind Denis Coleman into Symantec (NASDAQ:SYMC) and done just as well.

More recently, the five keys I just showed you led the Hidden Gems team to a double on online jewel retailer Blue Nile (NASDAQ:NILE) -- one of 16 Hidden Gems small caps that doubled or more in less than five years. (In the spirit of full disclosure, the Hidden Gems picks are up an average of 27%, versus 1% for the S&P 500.)

This market got you sick?
I don't think I've ever seen volatility like this. No wonder folks are getting defensive. Not me. I think this market's creating opportunities in great small companies with strong balance sheets and cash flows. I'm buying on dips. That's why I always have a wish list of great small companies on hand. You may need one, too.

If you're short on ideas, you can try out the complete Hidden Gems small-cap stock-picking service free for 30 days. You won't be pressured to join and you have a full month to decide if it helps you make money.

Meanwhile, you can check out every one of the team's small-cap value recommendations since Day One, including their five top picks for new money right now -- all free. To learn more about this special trial, 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 the results for every active and past recommendation, with your free trial. Amazon.com and Starbucks are Motley Fool Stock Advisor recommendations. Blue Nile is a former Hidden Gems and a current Rule Breakers recommendation. The Motley Fool has a disclosure policy.