(FORTUNE Small Business) – If you wanted to make money in small-cap stocks last year, the pickings were easy. Soon after we published our small-cap report in May 2003, those stocks went on a tear, posting record gains and giving investors their first real thrill since the late 1990s. Large-cap stocks did well too--the S&P 500 index of big-company stocks gained 20.7% between May 1, 2003, when our stock-picking issue hit the newsstands, and April 30, 2004--but small was sweeter. The Russell 2000, the index that tracks companies with market caps between $125 million and $1.5 billion, surged 42% during the same period.

Most of the companies we highlighted in last year's issue did even better than the Russell. To find our picks, we asked ten small-cap fund managers to recommend five stocks each. Several of those miniportfolios were up more than 100%, and one, assembled by Richard Driehaus of Driehaus Capital Management, was up 158%. (The complete list for 2003 is at fortune.com/fortune/smallcap.) While we're willing to take some credit--and the managers who made the picks deserve far more--the truth is that almost any portfolio of small-cap stocks would have made money in 2003. Why such rapid, broad-based gains? Eighteen months ago small stocks were still unwanted castoffs. "They got so oversold after the bubble of the late 1990s burst that they were incredibly cheap," says Glenn Primack, co-manager of FMI Focus, a small-cap fund that has an annual return of almost 19% over the past five years and ranks in the top 5% of its peers, according to Morningstar, a company that tracks the fund industry.

Add the Bush tax cuts of 2003 and some early signs of a recovering economy, and you had almost perfect conditions for a small-cap rally. "It was an unprecedented and extraordinary environment of stimulus," says Scott Brayman, manager of Sentinel Small Company, a growth fund that rose an average of 17.4% a year over the past five years (which handily beats the average of all small-cap funds--7.6%).

That was then, however, and this is now. After the big gains of 2003, finding attractive companies at reasonable prices has suddenly gotten a lot harder. The average P/E on the Russell 2000 was less than 25 in the spring of 2003, but by this March it had climbed to a pricey 32. And some seem to feel the market for small caps might be peaking: After pouring a near-record $24.4 billion into small-stock funds last year, investors started pulling money out this spring, according to AMG Data Service, a fund research firm in Arcata, Calif. During one particularly rough week in March, small growth stocks lost a net $922 million, a record.

To help us negotiate such a tricky market, we invited five of our ten managers back from last year, along with five new faces. All of them, along with experts who follow the small-cap sector, say investors should start by scaling back their expectations. "We think small caps are going to take a break," says Jim Furey, small-cap strategist at Lehman Brothers, who was predicting a 14% gain for 2004 until mid-March, then revised his expectations to about half that--7% at best.

That said, growing businesses at cheap valuations are out there--if you're willing to do the legwork. "You have to look under every rock for the really great opportunities," says Michael Balkin, manager of William Blair Small-Cap Growth, who hunts down undervalued stocks by spending about a third of his time on the road, meeting with the managers and owners of small companies. His fund gained 62% in 2003 and was up 6% this year through April 30.

For example, among this year's picks is ICU Medical (ICUI), recommended by J.B. Taylor, manager of Wasatch Core Growth. ICU makes proprietary intravenous machine parts that protect health-care workers and patients from infectious diseases such as HIV. Already some 70% of U.S. hospitals are customers, but the parts are disposable so there's no fear of market saturation. Earnings have been growing at a 21% pace for the past five years and are expected to continue at that clip.

Because small-cap investing requires so much research, plenty of investors avoid stock picking altogether and simply find a mutual fund they like. Unlike with large-cap funds, many of which charge you big fees and are essentially S&P 500 index funds in disguise, a talented small-cap manager can find gems that others have overlooked. Due to last year's influx of cash, some great funds have closed their doors to new investors (a record 24 small-cap funds closed in 2003, according to Morningstar). But that still leaves 547 to choose from. If you're comparing funds, look for managers with long tenure (five years, at a minimum), turnover rates of less than 100%, and reasonable expenses. Expense ratios can be a lot higher on small-cap funds, because the asset base is smaller (an average $532 million for small-cap funds, vs. $1.4 billion for large-cap funds). Aim to keep expenses below the average 1.67% for small-cap funds.

Whether you invest in small-cap funds or in the 50 stocks we've highlighted on page 76, realize this--the small-cap market might not see the returns of last year anytime soon, but it's still predicted to beat large- and mid-cap stocks for the foreseeable future. "If you look back to economic cycles since 1926, small stocks usually outperform big stocks for a little over seven years" coming out of a recession, says Kevin Hamilton, co-manager of Rice Hall James Micro Cap, up 4% through April. "Are we at the end? It's hard to say, but the probability suggests not, when you look at expected earnings growth ahead." The consensus on Wall Street is that earnings on the Russell 2000 will be up 51% this year and 31% next year (after a 71% gain in 2003). In contrast, earnings on the S&P 500 are expected to be up 19% this year and 12% in 2005.

In other words, the pickings may be scarcer, but you can still find some small-cap stocks out there with fruitful returns.