While the financial media spend much of their time obsessing over the largest companies in the stock market, small-cap stocks are quietly producing superior long-term returns. And micro-cap stocks have performed even better.

From 1926 through the end of 2011, smaller companies beat large caps by nearly 2.5 percentage points per year. Meanwhile, micro-caps–those with market caps ranging from $50 million to $300 million, though the definition can vary–further widened that gulf in performance by almost a point. That may not sound like much, but when compounded over such a long period, it adds up to a big difference in total return. 

Although the best micro-caps can become growth engines, earnings power alone can’t explain their outperformance. Nor can their sharply higher price volatility. Instead, some academics attribute their excess returns to two factors: paucity of information and lack of liquidity. 

Scarce Info

Despite the hordes of analysts on Wall Street, their ranks start to dwindle toward the bottom of the capitalization spectrum. This creates an informational vacuum that forces investors to do their own sleuthing when analyzing a micro-cap stock’s prospects. It also means that some of the most promising names can trade at a steep discount to their potential value, a pricing inefficiency that skillful investors can exploit. 

But it’s not easy. Because microcaps are still at an embryonic stage of their growth cycle, their financials can appear downright horrid, with many posting ongoing losses. So it requires no small degree of both diligence and intuition to see the better possibilities ahead for a young, growing company.

Limited Liquidity 

Beyond that, the micro-cap space is tiny–its aggregate market cap is around $270 billion. And many of its stocks are thinly traded, with some having trading volumes of just a few hundred shares per day. While part of that is the result of their relative obscurity, it’s also because corporate insiders hold a substantial number of shares outstanding–about one-third, on average.

That can severely limit a stock’s float, or number of shares available for trading by outside investors, making it difficult for investors to buy and sell shares without causing significant price movements. 

However, research has shown that some of the most illiquid micro-caps generated the best long-term returns. For instance, Morningstar conducted a study that found mutual funds that invested in the least liquid small-cap stocks outperformed those that held the most liquid small-caps by 4.3 percentage points annually over the 15-year period ending in 2009.

Part of the explanation likely has to do with the liquidity premium. Investors are willing to pay more for stocks that are easier to trade, so illiquid micro-caps offer a better relative value. That brings us to the other part of the explanation: Once others finally catch on to a rapidly growing name, the gains in share price can be explosive, as investors overwhelm a micro-cap’s usual trading volume. 

Stick with the Pros

While aggressive investors may find it tempting to abandon larger companies for the higher returns of micro-caps, there are clearly numerous hurdles to successfully navigating this space. And though micro-caps soundly beat the market over the long term, there are periods when smaller stocks lagged large caps, such as during much of the 1990s.

Still, smaller companies tend to have lower correlations to the broad market, and can therefore zig when the market zags. That may account for part of their outperformance since 2000, a period punctuated by two major downturns along with numerous smaller corrections. So it makes sense to maintain a small allocation to such stocks. Depending on individual risk tolerance, micro-cap stocks should probably comprise no more than 5 percent to 10 percent of an investor’s overall equity allocation. 

But this is one area where even self-directed investors are better off delegating to the professionals. While exchange-traded funds (ETF) are rapidly attracting investor assets thanks to low fees and tax efficiency, when it comes to micro-caps, it pays to invest with an actively managed mutual fund.

Micro-cap ETFs tend to deviate widely from their underlying benchmarks because they’re largely precluded from buying and holding the most illiquid stocks, which are the ones that generate the biggest gains. Additionally, since indexes announce their changes in advance, that leaves ETFs susceptible to traders front-running their benchmark. 

So which actively managed mutual funds do I favor for micro-caps? Since diversification is key when dealing with both the business risk and volatility in this arena, below I’ve highlighted three mutual funds that all produce similarly stellar long-term results.

Perritt MicroCap Opportunity (PRCGX) is one of the top-performing funds expressly devoted to the micro-cap space–the average market cap among the 108 stocks in its portfolio is just $226 million. Management defines its coverage universe as stocks with market caps under $500 million, though it will ride winners as high as $2 billion before finally selling them.

The fund gained 11.6 percent annually over the trailing 10-year period versus an 8.4 percent annual gain for the S&P 500. The fund fell hard in the bear market year of 2008, losing almost 47 percent. Even so, it’s still slightly ahead of the market over the trailing five-year period, though investors should be prepared to endure such a loss before investing in this fund. 

Nevertheless, prospective investors should have faith that the fund’s methodology will prevail over the long term. Michael Corbett, the current portfolio manager, has been at the helm since 1996, working alongside founder Gerald Perritt before assuming sole responsibility for the fund in late 2010.

I was fortunate enough to interview Mr. Corbett recently for Benjamin Shepherd’s Wall Street. He characterized his team’s investment process as essentially a series of tests. In addition to extensive research, they generate ideas via a network of regional brokers, investor relations firms, and numerous meetings with company executives both at their offices as well as at trade shows and conferences. In fact, Mr. Corbett says that roughly three to five management teams come through their offices each week.

Once they’ve identified a compelling name, they subject it to a nine-factor qualitative screen to assess its financial statements. If a company meets at least six of those criteria, they then perform traditional fundamental analysis to arrive at its valuation. They also continue meeting with company executives to determine their intent for the firm, such as whether they’re running the company to build it or sell it.

The next two funds I’ve identified aren’t explicitly micro-cap funds, though both have substantial allocations to the space.

Over 73 percent of Berwyn Fund’s (BERWX) 42 equity holdings are micro-caps. The average market cap of the portfolio’s holdings is $524 million.

The fund gained 12.9 percent annually over the past decade, but almost as impressive, it lost just 27.1 percent in 2008, nearly 10 percentage points less than the S&P 500.

Berwyn’s seasoned management team is led by portfolio manager Robert Killen, who launched the fund back in 1984. They employ a classic value strategy where they look for undervalued names that have fallen out of favor with the market, but have catalysts for a turnaround.

Management’s valuation discipline also helps mitigate risk. The fund will raise cash when it thinks stocks are overvalued or idle assets in cash until it finds suitable plays. That flexible approach enabled the fund to achieve its performance with the lowest volatility of the three funds profiled in this article. 

Finally, almost 60 percent of the more than 280 stocks in Royce Opportunity’s (RYPNX) portfolio are micro-caps. The average market cap of the portfolio’s holdings is $628 million. Over the past 10 years, the fund gained 13.6 percent annually.

Royce Opportunity’s lead manager has run the fund since 1998 and uses a deep-value approach to identify promising names among such beaten-down fare as undervalued asset plays, turnarounds, special situations (including firms emerging from bankruptcy), and busted IPOs.

Although management attempts to keep a lid on volatility by capping individual positions at no more than 1 percent of assets, the fund is still far riskier than the Russell 2000. As evidence of the fund’s risk profile, it lost almost 46 percent in 2008.

All three funds have limited overlap among their top holdings and reasonable expense ratios, making them the perfect trio for a micro-cap allocation.