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

$725

1,118%

Range Resources (NYSE: RRC)

$444

654%

Ultra Petroleum (NYSE: UPL)

$1,411

323%

Hologic (Nasdaq: HOLX)

$301

264%

Arcelor Mittal

$857

214%

Data provided by Capital IQ, a division of Standard & Poor's.

Simply put, the smallest companies have much more upside than the largest. But be aware: Higher potential reward comes with higher risk. Buy one of the worst-performing small caps, and you'll likely earn a total loss of capital -- which is a fancy Wall Street phrase for "losing all your money." That's why at Hidden Gems, we seek only the highest-quality small caps: those with high insider ownership, a strong balance sheet, a solid business model, and compelling valuation.

It's time to think small
Using these principles, the HG team's stock recommendations have outperformed the S&P 500 by an average of five percentage points since the service began more than five years ago. This track record shows that small caps can indeed improve returns, and should be a part of any balanced portfolio.