(FORTUNE Small Business) – We became fascinated with small public companies about a year ago when we were compiling the first edition of the FSB 100, our list of the fastest-growing businesses, which we'll publish again in July. We found terrific tales of entrepreneurial accomplishment, of course. But we also saw some potentially great investment opportunities for readers who were fed up with the newly lackluster S&P 500 index. Wall Street was sending some interesting signals: Large-cap stocks were going out of style, and small was back in vogue.

If you listened to those signals last year, well, congratulations. During the 12 months ending in February, large-company stocks were pounded as the Dow and S&P 500 indexes sank 3.7% and 9.5%, respectively. The reasons, by now, are well known: Sept. 11, recession, Enron, inventory glut, and the end of investors' love affair with tech. Small-cap stocks, in the meantime, have held up just fine, thanks, returning 14.1%. Today small caps are the biggest thing on Wall Street. Usually by the time you read about a hot investing trend in a magazine, you've already missed the boat. According to the experts we've consulted, that isn't the case here. That's why we've put together this package to explain the ins and outs of small-cap investing, complete with an overview, some stock picks, and a mess of profiles.

GUT CHECK But first a warning: Small-cap investing is not for the faint of heart. These stocks are more volatile than their larger counterparts. One mistake, which could be better absorbed by a big company, can cause serious damage to a smaller one. That alone may be reason enough for our readers to stay away from small caps. "Small business owners tend to be more conservative investors," says Wayne von Borstel, a financial planner in The Dalles, Ore. "As they pull money out of their risky venture, their business, they want to put it into something safer."

But there's a flip side to that coin, and it's the reason that small-cap stocks tend to benefit most when the economy emerges from a recession--as most people think it's doing now. Just as smaller companies are more vulnerable to failure, they're also more likely to benefit from the cost cutting that occurs during a downturn. "Is GE going to significantly affect its earnings with a little cost cutting?" asks ING/Pilgrim's chief investment officer of domestic equities, Mary Lisanti. "I don't think so." Historical data back her up. In the year following the previous nine recessions, in fact, small caps have beaten the large caps by an average of 18 percentage points, according to Ibbotson Associates.

This opportunity has been a long time coming. There wasn't a recession to be found in most of the 1990s, and small caps floundered. In the second half of the decade, large caps outperformed small caps by an annual average of ten percentage points. Strip out the dot-coms and it's a blowout. "It all reached a crescendo in 1999 when Yahoo entered the S&P 500," says Whitney George, manager of the Royce Low-Priced Stock fund. "People were telling me that small-cap and value investing were dead." Now the small-cap club is in the spotlight again. In 2001, for example, small-cap value stocks--companies that are attractive because of their cheap price, rather than growth stocks that are traded based on future prospects--were the most successful equity category, period. Large-cap equity fund managers watched helplessly as $35 billion dripped out of their coffers and $28 billion flowed into small-cap funds. (The trend still holds. Large-cap funds lost $1.4 billion in the first two months of 2002; small-cap funds gained $7.4 billion.)

WHAT NOW? That may be of historical interest, but there are plenty of reasons to believe that this small-cap rally has several years left in it. For starters, fund managers and analysts say that historically the average small-cap bull market lasts five years. By even the most conservative estimates, then, we still have another two or three years of small-cap dominance ahead of us. Or as Dan Veru, manager of GE Small-Cap Value Equity, puts it, "I think we're in the second inning of a nine-inning ball game."

Then there's diversification, which is suddenly hot post-Enron. "After the butchering, when we're laid out on the breakfast table, that's when diversification makes sense," says von Borstel. There's plenty of room for improvement. Financial planners recommend that people invest 15% to 20% of their 401(k) equity investments in small caps. Today the national average is just 2.6%.

Low interest rates--the lowest in 50 years--also provide a great opportunity for small companies looking to grow. Compared with bigger firms, small companies are more reliant on bank loans to raise money. "[Small companies] don't require access to the capital markets like large companies do," George says. "Even as interest rates rise, it is unlikely the capital markets will return to the feverish pace of the late '90s."

Finally, and most important, despite small-cap stocks' outperformance, they are still relatively cheap. With a median P/E of about 14, small-cap stocks fall somewhere in the middle of their historical valuation levels during the past 25 years, according to the Leuthold Group, an investment research firm. Meanwhile, large caps are trading at a median P/E of 25, near the top of their historical range.

"I was worried at the end of last year that small caps had gone up too much--ultra-small, especially--and that valuations wouldn't be as good," says Bridgeway Funds founder John Montgomery. "That hasn't happened, which is to say there are a lot of good pickings out there."

HOW TO PLAY IT Still, knowing where to start looking can get a bit tricky. After all, if you're thinking about investing in a blue chip, there are plenty of analyst reports to help you decide. Small caps, on the other hand, "are underowned and underfollowed, and they're more illiquid," says RS Diversified Growth's John Wallace. And in the riskier world of small-cap investing, it's important to spread the wealth to shield yourself from the inevitable flameout. "I can guarantee you that I'll have three to five disasters this year," says Boniface "Buzz" Zaino, manager of Royce Opportunity. "What offsets the disasters are those few that do extraordinarily well."

That means that if you're going to invest in individual small-cap stocks, make sure you dig in, says RS Diversified Growth's John Seabern. Yes, that means poring over earnings reports and keeping track of industry trends. If you don't have the time or the patience, you might be better off with small-cap mutual funds. Unfortunately, picking a small-cap fund isn't quite as simple as dumping your cash in an index fund. In fact, it's probably best to stay away from most small-cap index funds. But don't take our word for it. Here's John Bogle, the inventor of the index fund and the loudest proponent of index funds generally: "I'm a big fan of indexing overall, but I'm not in favor of the small-cap indexes we have," he says.

The problems start with the Russell 2000, on which most small-cap index funds are based. When a stock performs well, it graduates to mid-cap or large-cap status and leaves the index altogether. And, says Montgomery, by the time a stock hits the Russell 2000, it's already too expensive. The reason? Wall Street typically "front-runs" the index--purchasing individual stocks analysts know will be included in the Russell 2000 before it is rebalanced. "Front-running wreaks havoc on the stocks entering the index," Montgomery says.

If you can't bear to turn away from index funds, we do have one to suggest: Bridgeway Ultra-Small Company Tax Advantage, which is based not on the Russell but on an index that tracks the smallest companies trading on the New York Stock Exchange. It's cheap, the index doesn't face much front-running because it isn't widely followed, and it seeks to capture the returns of the smallest companies, the ones with the greatest potential for long-term return. Since its inception in 1997, the fund has beaten the Russell 2000 by 15 percentage points a year.

But if you're not allergic to fees, we recommend an actively managed fund. Here, too, you'll face some challenges. In fact, look for the same characteristics in a fund that you would in a stock--a relatively undiscovered "diamond in the rough." Once a leading small-cap fund starts taking in large amounts of capital, it becomes harder for the manager to find places to invest that cash, says Ryan Crane of AIM Small Cap Growth. Since the law requires that a fund own no more than 10% of any one stock--and with small caps, that number can be reached pretty quickly--popular managers have to continually beat the bushes to find new targets.

That's why some companies turn money away. Many of the most successful small-cap funds, like Wasatch Small Cap Growth, are refusing new investors. But there are still some gems out there. GE Small-Cap Value Equity holds just $65 million worth of assets and has outperformed 85% of all small-cap growth-and-value funds in the past three years. With $739 million in its coffers, Royce Low-Priced Stock is larger but still attractive. The fund ranks in the top 5% of all small-cap value funds over three and five years.

Despite the potential pitfalls, small-cap stocks cannot be ignored. Consider this: Going back to 1927, small companies have outperformed larger ones by about two percentage points a year. Doesn't sound like much? If you were to invest $10,000 in each group (and you were able to capture the market's returns over 30 years) that difference would net you an extra $137,000. Not bad for a bunch of companies you've never heard of.