NEW YORK (FORTUNE) - To find profitable and well-managed small caps (companies with market values of $250 million to $2 billion), we followed Chuck Royce's technique of requiring at least an 8 percent return on assets (net income divided by total assets) and positive free cash flow. We screened for stocks with low P/E and price-to-book ratios relative to the Russell 2000 index.

And we considered only companies with stock prices no higher than $35 a share, because they are less likely to be covered by Wall Street analysts and less likely to be heavily owned by institutions, which creates more opportunities for individual investors to get an edge.

Continuing their strong run, small-cap stocks have risen almost 50 percent since the end of 2000. Our small caps turned in a solid year, delivering a 20 percent average gain.Lincoln Electric (Research) and Arkansas Best (Research) (up 44 percent) did so well that they no longer qualify as small caps, according to our screen.

A new addition is Chattem (Research), which makes niche health-care products, including Selsun Blue shampoo and Pamprin pain reliever. CEO Zan Guerry has pursued a clever strategy of acquiring highly profitable brands abandoned by large consumer product and drug companies. This year Chattem is launching a new appetite suppressant, sunblock, and other products that should give profits a lift in 2007. Yet at 16 times earnings, the stock sells for less than half the multiple of the Russell 2000 small-cap index.

• Small-company stocks (with market caps between $250 million and $2 billion) have been among the market's best performers in recent years.
• When investing in small caps, look for strong balance sheets--financial strength is crucial for these more fragile firms.
• Successful small caps can grow into mid-caps and mega-caps ... losers can disappear. So be prepared for volatility.