(FORTUNE Small Business) – At a time when even the brashest economist is reluctant to predict the tides, much less the ripples, of the stock market, it's a bit refreshing to hear what Jim Oberweis Jr. has to say about the future of small-cap stocks. "I'll go out on a limb," declares the president of Oberweis Asset Management, a North Aurora, Ill., small-cap investment manager. "I predict double-digit positive returns from here to the end of the year."

We'll let him make those risky pronouncements; you won't hear any guarantees from us about how small caps will perform this year. After all, most experts expected small caps to make a statement last year, and they were convincing enough for us to declare small-cap investing "back in vogue" in our May 2002 issue. Some fashion trend: By year-end, small caps were so unpopular they made pantsuits look like Prada. Total return for the Russell 2000 (an index that tracks companies with market caps between about $125 million and $1.3 billion) was down 20%. Perhaps the only consolation--a slim but significant one--was that the larger S&P 500 fell even more, by 22%.

Of course, 2002's obliteration was brutal only if you happened to sell small caps in 2002. For buy-and-hold investors, the pain was just on paper. Now comes a possible upside: Many small caps have been knocked down to bargain-basement prices and are poised to rebound.

So, what exactly went wrong last year? First, let's give discredit where discredit is due. Small caps underperformed, but so did blue chips and mid-caps. More than anything, 2002 was an instance of a falling tide lowering all ships. Or more aptly, a raging tsunami demolishing all ships. "There was no place to hide last year," says Jack Laporte, manager of T. Rowe Price's New Horizons fund. "Everything went down together. The bear market finally caught up to small caps."

So far 2003 has not been kind to small caps either. During the first three months of the year total return for the Russell 2000 dropped 3.4%. Now small caps are actually lagging behind their large-cap brethren, which lost 1.4% over the same period. During the first quarter of 2003 small-cap mutual funds were socked with net outflows of $3.6 billion, according to AMG Data Services. For the same period in 2002, small caps took in $16.4 billion. Large-cap funds also had a rough first quarter, with net outflows of $8.6 billion. But that represented a 0.5% erosion of their total asset base, while the $3.6 billion hit taken by small caps diminished their cumulative base by a full 1%. "Outflows were more meaningful and more painful for small-cap funds," says Steven DeSanctis, director of small-cap research at Prudential Securities.

In part, you can blame this bias against small caps on the aforementioned jittery economic picture and on the war with Iraq, which still raged as we went to press. Deservedly or not, small companies have been the victims of what's known as a "flight to quality." In the face of so much uncertainty, people are inclined to invest in IBM or GM--companies that have existed for decades--over a fledgling outfit with a $300 million market cap. "There is a perceived safety in size," says W. Whitney George of Royce Low-Priced Stock fund. "For small caps it may be tough sledding for a while."

We'll repeat that. Heck, we'll even put it in capital letters: SMALL-CAP INVESTORS COULD STILL FACE A ROUGH COUPLE OF YEARS. That said, experts think now may be an excellent time to consider investing in small-cap stocks. Here's why: They almost always take the lead in an economic recovery. During the five years following the bear market of 1973--74, for example, small-cap total return outpaced large caps, 40% to 18%. In the years 1932 to 1935, coming out of the depths of the Great Depression, small caps returned 41%, vs. 20% for large caps. Assuming this country finds its way out of its current malaise, most people expect small caps to outdo the rest of the pack once again. "I don't see any reason why history won't repeat itself," says Laporte.

Small caps do well in economic recoveries precisely because of their size. While large corporations tend to have hidebound cultures in which they have to do umpteen studies before they can make a move, smaller companies have the flexibility to act quickly and take advantage of good times. What's more, many small caps operate only in the U.S. market. Such companies risk disproportionate suffering when the U.S. economy is in the doldrums, but when things heat up, they have the potential to grow at a pace well beyond the reach of a diversified multinational behemoth. Among the portfolio managers' 50 picks this year--which can be found on the pages following this article--five companies have exclusively domestic operations: Hot Topic, Yardville National Bank, Bank of the Ozarks, E-Loan, and P.F. Chang's China Bistro.

Bear in mind there are a vast number of small companies from which to pick. There are roughly 20 times more small caps than there are companies in the S&P 500. Put another way, no matter how poorly the overall economy is doing, it is always possible to find a small cap that's thriving. "It's an evergreen universe," says Royce's George. Of course, it's difficult for individuals to outperform professional stock pickers. But here's one study tip: Look for a company that has no real competition--such as a firm with robust patent protection or one that dominates a niche market. (Some examples of good niche picks: P.F. Chang's, the country's only chain of upscale Chinese restaurants, and United Natural Foods, the only nationwide distributor of natural foods and products.)

Let's admit that small-cap investing isn't the most glamorous strategy. If it's cachet and respectability you're looking for, you might be better off investing in some universally admired blue chip. Trouble is, you're much less likely to beat the market that way. It's nearly impossible to find some undiscovered upside in, say, Cisco's latest earnings report: 37 professional analysts have pored over every morsel of information before you. Many small companies, by contrast, have virtually no analyst coverage, especially as recent staffing cutbacks have forced investment banks to focus more on the GMs and Wal-Marts of the world.

Small caps have their share of unseemly traits, though, not the least of which is their white-knuckle volatility. From 1926 through 2002, according to Ibbotson Associates, the standard deviation for small caps was 33%. For the same period, the measure for large caps was 20%. That means that you can expect your small-cap portfolio to be a bit bipolar: Its upswings will be much higher, and its plunges will fall much further. (One example: Pemstar, a manufacturing company for the tech industry that was one of last year's 50 picks, fell 81% in 2002.)

Another caveat about small caps: they don't tend to pay dividends. Until very recently that was a nonissue. But at presstime President Bush was still pushing a plan that would cut taxes on dividends--making stocks that paid them much more attractive. Should that plan pass, investors could see some migration from small caps to large caps. Only ten of FSB's 50 picks pay a dividend. The good news is that even the President's supporters in Congress don't expect the dividend tax cut to pass. "On the day the plan was announced I was nervous," says Oberweis. "It's still definitely a concern."

One final small-cap downside is lack of diversification. Sure, you can buy a company that's camped out in a tiny niche, serving only the domestic market. Bet right and the sky's the limit. But if you bet wrong ... Meanwhile, purchasing even a single large stock such as GE or Johnson & Johnson lets you spread your risk out a bit, because such companies operate in dozens of business lines in scores of countries. You can get around that by buying a bunch of small caps, although that requires a commensurate increase in legwork. An even better alternative is to purchase a mutual fund. "You never know when the market's going to reward a company," says John Richardson, senior portfolio manager at Munder Small-Cap Value. "That's why I own 90 stocks."

Small-cap value funds, it's worth noting, were the best-performing category of any asset class for the years 2000 to 2002. Unfortunately, this past year "best performing" simply meant losing 10%, vs. a 22% loss for large-cap funds. Still, don't be too quick to dismiss the little guys. In the current climate their performance is not nearly as bad as it sounds. "All asset categories showed negative growth this past year," explains DeSanctis of Prudential. "Given the investment climate, it was a big victory to be down only 10%."

At some point the market will recover, and if history is any guide, expect small caps to lead the pack. "Roughly 40% of institutional money is invested in just 39 stocks," explains Dan Veru, portfolio manager of the GE Small Cap Value Equity fund. "The largest names are widely over-owned and overvalued. You need to look beyond the top names. Companies that nobody has ever heard of are where you will make all the money going forward." That makes two fund managers willing to try to make the case for small caps. It may not be an ironclad guarantee, but we challenge you to find anyone making such bold pronouncements for the S&P 500.