Investors have a natural attraction to large-cap stocks -- understandably so. Everyone's heard of Cisco Systems and Coca-Cola (NYSE: KO), after all, and most know what they do to generate revenue. There's also abundant analyst and news coverage for large caps, so we all have a good way of knowing what these firms are up to. Sounds like a great deal, right?

Well, it is -- if you want to settle for lower returns.

Why you need small caps
According to research from NYU professor Aswath Damodaran, studies have consistently found that smaller firms "earn higher returns than larger firms of equivalent risk." During Damodaran's study period of 1927 to 2001, the smallest companies outperformed the largest ones, with a 20% annual return versus 12% on a value-weighted basis. The outperformance was even greater on an equally weighted basis.

One reason is that small caps, being, um ... small, simply have more "room to run" than the big boys. You can get a better sense of this by looking at the top-performing large- and small-cap stocks over the past five years. First, a sampling of the top 20 companies with a market cap of more than $50 billion five years ago:

Company

November 2003 Market Cap
(in billions)

Return since November 2003

China Mobile (NYSE: CHL)

$56.0

204%

ExxonMobil (NYSE: XOM)

$239.8

118%

PepsiCo

$82.3

13%

Toyota (NYSE: TM)

$101.5

0%

Coca-Cola

$114.5

-3%

Now, here are some of the companies among the top 20 best performers with a market cap between $200 million and $2 billion. That's the universe we search to make recommendations for our Motley Fool Hidden Gems small-cap investing service:

Company

November 2003 Market Cap
(in millions)

Total Return
(November 2003 to November 2008)

Southwestern Energy Continued...