(FORTUNE Small Business) – Last year at about this time we wrote that small-cap stocks as a group weren't likely to outperform the broader market. Well--deep breath--we were wrong. The Russell 2000 index of small caps posted an impressive 18% return for 2004, vs. only an 11% rise for the S&P 500 index. The good news is that we also said 2004 would reward savvy pickers of individual stocks, and listed 50 favorites of ten leading small-cap-fund managers. Had you bought that portfolio, you would have watched your investment grow 19%.

This year our experts are sticking to their guns: They remain cautious about the sector but optimistic about their portfolios. The consensus is that while small-cap stocks and funds deserve a place in almost every investment strategy, indexes of these stocks will probably not beat the broader market for yet another year. Historically, the small-cap and large-cap sectors have alternated as market leaders, with the average small-cap winning streak lasting roughly three years. But 2004 was the sixth year in a row that small-cap stocks outperformed large caps, a feat surpassed only once in the past 78 years. While none of our managers would predict the end of the rally, all agree that it's on its last legs. Says Mike Corbett, whose Perritt Micro Cap Opportunities fund has delivered, according to Lipper, Inc., an average annual return of 25% over the past three years: "The easy money has been made."

So what's an investor to do? Andy Pilara of perennial investment powerhouse RS Investments says, "The way to do well is on a company-by-company basis." Fund managers agree that great opportunities are still available to those who invest in promising individual stocks. To help find some, FSB again asked ten top small-cap managers--three of whom were invited back from last year based on their strong track records--to list five stocks with market capitalization of $1.5 billion or less that are likely to beat the market over the next year. Of course, these managers have a vested interest in having you buy their picks, but we do believe they have credibility because they've outperformed the market over time.

Small-company stocks naturally are riskier and more volatile than those of big, established companies, which have the financial reserves and brand equity to ride out tough times. Further, even the strongest small caps have trouble making good use of the volume of capital that big institutions need to invest. Thus, many small companies remain out of favor on Wall Street, and many investment houses have cut back on their research coverage, dulling investor interest even more. Yet with risk comes reward. Since 1926 the average annual return of small-cap stocks has bettered that of large caps by at least two percentage points. And the investing world's biggest winners are those who invest early and often in small caps that get big quickly.

So where do you find these gems? This year, as in previous years, our fund managers looked for companies with first-rate management, a compelling business model, and a great price. And then there are what growth investor Ron Baron, founder of Baron Capital Group, calls the "megatrends" that color the midterm investment picture. For example, says Baron, "the country is under attack. Companies that can help the government protect us look interesting."

Another such megatrend is China's seemingly insatiable demand for natural resources, which has a number of our experts placing big bets on commodity companies. John Keeley, founder of Keeley Asset Management in Chicago, calls this the "reawakening of the heartland of America" and expects it to continue. Pilara of RS Investments agrees. "For the next five years I think things look terrific in commodities," he says. In particular, Pilara likes a company called Century Aluminum. The company focuses on raw aluminum--and has the majority of its smelters in the U.S. "The price of aluminum has been a laggard as far as most of the other commodities are concerned," explains Pilara. "China has been a huge exporter of aluminum, which has depressed the price." However, the Chinese government has begun to discourage aluminum exports via the elimination of a key rebate and the imposition of an export tax. The result is a likely increase in pricing power for U.S. producers, and Pilara feels Century, whose sales grew 35% last year to $1.06 billion, is well positioned to exploit the opportunity. Pilara sees the stock hitting $38 in the next few years--for a 20% gain over its current price of $31.79.

With the spread of satellite and cable TV, DVDs, and pay-per-view, the demand for popular movies is booming worldwide, and one stock particularly well poised to benefit is Lions Gate Entertainment. The company owns the largest independent film library in Hollywood and is the distributor of last summer's box office hits Fahrenheit 9/11 and Open Water, as well as the upcoming House of D, starring David Duchovny and Robin Williams. In the third quarter ended Dec. 31, revenues were up an impressive 170% over the previous year, and the company returned to profitability after having fully absorbed the costs related to the savvy acquisition of rival Artisan Entertainment in December 2003. Lions Gate is on track now to deliver nearly $800 million in revenues by the end of its fiscal year in March. Mike Balkin, whose William Blair Small Cap Growth fund has generated, according to Lipper, 22% average annual returns over the past three years, thinks the stock, which is now trading at $10.90, could hit the "mid-teens" in fiscal 2006. Balkin says his main reason for investing in Lions Gate is the proven management team. "We like to bet on the jockey instead of the horse," he says.

As baby-boomers age, many health-care companies are poised to profit. ArQule, a small biotech firm with heavyweight partners such as Novartis, Pfizer, and Roche, has developed a new "small-molecule therapy" that promises to help treat a wide range of cancers in a way that is less toxic than conventional chemotherapy. In 2004 sales hit $54 million, but over the past two years ArQule has lost nearly $40 million, and it projects a loss of $24 million to $28 million in 2005. Most of these losses, however, result from research spending, including a $30 million charge related to the acquisition of another biotech company, Cyclis Pharmaceuticals. Bridgeway Capital's John Montgomery expects the R&D will pay off. As a quant investor, Montgomery barely knew what ArQule did when he proposed it for our list. His computer models, however, showed that the company has the sort of numbers he likes: "All kinds of cash, positive cash flow, fundamentals going in the right direction and accelerating," explains Montgomery. The stock recently traded at $5.03, and while Montgomery can't give an exact target price, he thinks it has the potential to triple or quadruple. His 26% average annual return over the past ten years--the best in his category--makes this a prediction worth noting.

With 31% of American adults now classified as obese, a lot more are likely to be heading to the gym. Waiting with open arms is Nautilus Group, maker of the Bowflex, the heavily advertised fitness machine. After years of uncertain performance, Nautilus, says Rice Hall James analyst Tom McDowell, now has a first-rate CEO who has refocused the company and is squeezing more out of its impressive portfolio of fitness brands, which includes Schwinn and StairMaster. Revenues were up a modest 5%, to $524 million, in 2004, but McDowell projects 67% growth in earnings per share by 2006. The stock was recently trading at $22.20 with a trailing P/E of 25.

One possible beneficiary of homeland-security spending is Flanders--based in St. Petersburg, Fla.--which makes high-quality air filters. Government agencies, including the Pentagon, have begun to place orders with Flanders for air filters that can neutralize anthrax and other chemical and biological weapons. Mike Corbett of Perritt is optimistic that many more contracts are coming. "Flanders wouldn't be building a several-hundred-thousand-square-foot manufacturing facility if it didn't think it would be getting these agreements," he says. "The bottom line is, there are no filters out there in the market anywhere close to what they provide."

Corbett first heard about Flanders on a tip in 2002, when the stock was selling for less than $2, and he liked the story enough to buy 300,000 shares. Now the stock is at $10.60, and Corbett is still buying. In its core business of making filters for cooling and heating systems, the company is gaining market share on competitor 3M and has won Wal-Mart's Supplier Award of Excellence. In 2004 it saw its revenues grow 9%, to $200 million, and chalked up earnings of $10 million. The stock's trailing P/E of 30 is high, but Corbett expects Flanders's earnings to double or even triple again in the next few years.

Over the past few years, the P/E ratios for small-cap stocks have reached rough parity with those of large caps, and some see this development as evidence that small caps are now expensive, especially on a risk-adjusted basis. But small caps have historically traded at a premium to large caps--the small-cap discount that has persisted since the late 1990s is an historic anomaly. As Mike Corbett says, "I can sit here and give you a list of small companies that are trading at the same P/E as GE, and their growth rate is two or three times greater. And you're supposed to buy GE? I don't get that." Neither do we.

We asked ten analysts from some of the nation's top-performing small-cap stock funds to name five picks they believe will outperform the market this year. Last year's selections as a group rose 19%, vs. only 11% for the S&P 500 index.