While the financial media spend much of their time obsessing over the largest companies in the stock market, smallcap 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 largecaps by nearly 2.5 percentage points per year. Meanwhile, micro-caps— those with market caps ranging from $50 million to $300 million—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, micro-caps 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. One possible explanation is that when 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.

So 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.

Furthermore, this is one area where even self-directed investors are better off delegating to the professionals. That’s one of the reasons why we were excited to interview the portfolio manager of Perritt MicroCap Opportunities (PRCGX) for our “Across the Street” feature (See p. 2).

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. 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.

But since diversification is key when dealing with both the business risk and volatility in this arena, below we highlight two other mostly micro-cap funds that produced similarly stellar long-term results. We previously profiled Berwyn Fund (BERWX) in our August issue—over 73 percent of its 42 equity holdings are micro-caps. The fund gained 12.9 percent annually over the past decade.

Finally, almost 60 percent of the more than 280 stocks in Royce Opportunity’s (RYPNX) portfolio are micro-caps. Over the past 10 years, the fund gained 13.6 percent annually.

Despite their portfolios having average market caps well below that of the small-cap Russell 2000, both Perritt and Berwyn achieved their performances with risk largely in line with the index, while Royce’s volatility was substantially higher.

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