The Best Small Companies ... Exposed

It's hardly breaking news at this point, but it bears repeating: Small-cap stocks are your best bet for superior returns. After all, small-cap stocks have trounced their larger brethren over the past 80 years -- and over the past three decades, the competition hasn't even been close:

Annualized Return	Small Caps	Large Caps
1926 to 2006	12.7%	10.4%
1976 to 2006	17.5%	12.8%

Data from Ibbotson Associates.

Meanwhile, a recent study by Jeff Anderson and Gary Smith from Pomona College shows that America's most admired companies also have a tendency to beat the market. Anderson and Smith analyzed the returns of Fortune's list of the 10 most admired companies from 1983 to 2004. They found that a portfolio of these stocks outperformed the S&P 500 by "a substantial and statistically significant margin."

By the power of the transitive property
So it stands to reason:

A. If investing in small-cap stocks generates market-beating returns, and ...
B. If investing in the market's best companies generates market-beating returns ...
C. Then investing in the market's best small-cap companies should generate market-annihilating returns.

If only there were a list of the best small-cap companies ...
Fortunately, the folks over at Forbes magazine compile an annual list of the 200 best small companies in America. According to Forbes, companies "must pass through a gauntlet to qualify for the list," so you know you're getting the cream of the crop.

To make Forbes' list, a company must have revenue between $5 million and $750 million and a share price higher than $5, and must also clear certain thresholds for returns on equity, sales, and income.

That's some list
As you might expect, Forbes' list boasts some impressive names and more than a few familiar faces. The list successfully identified small-cap stalwarts such as Buckle (NYSE: BKE), Green Mountain Coffee Roasters (Nasdaq: GMCR), and Strayer Education (Nasdaq: STRA) long before they emerged from the pack.

Forbes was also early to the party on success stories such as Copart (Nasdaq: CPRT), Citrix Systems (Nasdaq: CTXS), and Fastenal (Nasdaq: FAST). Look at the returns:

Company	First Appeared on the Forbes List	Return Since First Appearance*
Buckle	Oct. 3, 1996	693%
Citrix Systems	Sept. 26, 2002	472%
Copart	Oct. 1, 2000	266%
Fastenal	Oct. 3, 1996	193%
Green Mountain Coffee Roasters	Oct. 1, 2000	2,789%
Strayer Education	Oct. 2, 1998	736%

*Returns through July 16, 2009.

But you can only look backward through a screen
Forbes' list does an excellent job of identifying the hottest small-cap companies -- at the moment the list is released. After all, the data Forbes is taking into account is primarily backward-looking.

Clearly, some of these companies continue to excel long after they're featured in the magazine. But for every Green Mountain Coffee Roasters, there's a company likeNutriSystem (Nasdaq: NTRI), which debuted at No. 1 on Forbes' 2006 list and ranked second in 2007.

Although NutriSystem has been in business since 1972, the company only began to capture investors' attention after executing a successful turnaround earlier this decade. Thanks to a reinvigorated brand and an increased marketing presence, NutriSystem has grown revenue at a compound annual growth rate of 114% over the past five years. However, a recent slowdown in sales has the Street seeing signs of another Atkins-style fad diet flameout. NutriSystem shares are down 67% from when they appeared on Forbes' 2007 list.

I won't bore you with Forbes' other big misses, but suffice it to say, there have been more than a few. In fact, six of Forbes' top 10 stocks from 2008 are in the red, and four of those stocks are down more than 30%!

Don't send a screen to do an investor's job
A stock screen is a great tool for identifying prospective opportunities, but it's no substitute for good old-fashioned due diligence. At Motley Fool Hidden Gems, our team advises investors against searching for winning small-cap investment ideas by seeking out the hottest companies of the past 12 months. Instead, the HG team focuses on companies with:

• Solid free cash flow
• Strong balance sheets
• High insider ownership
• Market-beating potential over the next three to five years

Furthermore, the HG team prefers small companies that are obscured from Wall Street and ignored by the financial media. It's far more profitable to unearth quality companies before they become household names than after they grace the cover of a magazine.