Published: November 12, 2010

"So, Lou... are you worried about buying small-cap stocks now, given the market's huge run-up?"

This was the question that Frank Curzio put to me, as I was being interviewed on S&A Radio last week.

My answer: I'm always cautious about buying into a rally... but at the same time, opportunities always exist.

The question is: How do you find the best of the bunch?

Here are my three "secrets" to finding winning small-cap stocks in this market...

Small Cap Secret #1: Stick to the Technology Sector
The reason I recommend sticking to the technology sector is two-fold...

Momentum is a powerful market force. We should use it to our advantage, instead of trying to fight it. And the technology sector stands out as one of the market's best performers lately.

For example, since the start of the fourth quarter, the average technology stock is up about 10%, according to Standard & Poor's. Only energy stocks (up about 11%) are faring better.

More important than momentum, though, is the fact that technology companies represent the Olympic athletes of the investment world. They entered the recession in peak financial shape with barely any debt and a surplus of cash.

By contrast, financial stocks (banks, real estate investment trusts, etc.) represent the sickly hospital patients of the investment world. They entered the recession on a gurney and headed straight into the emergency room, bloated with too much debt and balance sheets full of toxic assets.

Put simply, technology companies were the best equipped to handle the economic downturn. In turn, they were destined to emerge the strongest. And that's precisely what's happening...

Tech Companies Splash the Cash
According to the latest tally, the top 25 technology companies are sitting on $486 billion in cash. And they're putting it to work, too.

In the third quarter, the number of mergers and acquisitions in the technology sector jumped by 43%. This level of dealmaking proves that technology companies are clearly focused on growth. And that's crucial for investors because growth ultimately increases earnings and share prices.

Meanwhile, many other companies are still cash-poor and struggling to survive. So when it comes to stacking the odds in our favor, bet on the athlete, not the infirmed.

Small Cap Secret #2: Stick to "Forever-Growth" Trends
Just because technology stocks boast solid momentum and financial strength doesn't mean that we should ignore the bigger macroeconomic picture.

As I explained in the summer, the chance of a double-dip recession in the United States is slim. But the fact remains - the current economic landscape hardly engenders optimism. Heck, Jeremy Grantham thinks the recovery will be so anemic that we're headed for "seven lean years" of equity returns.

I don't agree with such a bearish view. Nevertheless, I do want to guard against any short- to intermediate-term economic hiccups. And the easiest way to do that is to focus on forever-growth trends. In other words, trends destined to continue, no matter what happens in the world.

Do such trends exist? Absolutely. Just look at the mobile phone you probably have within arm's reach at this very moment.

It's become a truly indispensable part of everyday life. If you have any doubt, try turning your phone off for a solid week. I guarantee you can't do it. That's because we can now use our phones for texting, e-mailing, surfing the Internet, watching videos, streaming music, getting directions, "tweeting," sharing photos and wiring money. And more functions and applications are being added almost daily.

So much so, in fact, that Cisco (Nasdaq: CSCO) estimates that global mobile data traffic will be 39 times higher than current usage by 2014. Before long, our mobile networks will process the data equivalent of all the words ever spoken by human beings... every month!

Add it all up, and no matter what happens in the world or with the economy, you can rest assured that we won't stop using our mobile phones. For obvious reasons, investing in forever-growth trends like this makes total sense.

Small Cap Secret #3: Stick to Stocks That Wall Street Doesn't Follow
The trick to profiting from such trends and finding the best stocks with the most upside potential is easy.

Just stick to small-cap stocks that have little Wall Street analyst coverage. This is the only area of the market where individual investors like us still hold the advantage.

Why? Because big institutions can't buy such small stocks. They control too much money and it would unfairly impact prices. Even Warren Buffett acknowledges this reality. He said he could earn 50% annual returns each and every year if he only had $1 million to invest, because it would give him free rein in the market.

In the end, Wall Street has to wait until the most compelling small caps become mid caps or even large caps in order to profit. So they don't spend much (if any) time researching such opportunities.

But we have no limitations. And if we're willing to get our hands dirty, we can dig up these companies early and capitalize on the growth immediately.

Exploiting such an advantage almost always translates into bigger profits. Or as famous mutual fund manager, Peter Lynch, said: "If you find a stock with little or no institutional ownership, you've found a potential winner. Find a company that no analyst would admit to knowing about, and you've got a double winner."

-- Louis Basenese
Small Cap Expert
Investment U

Note: This article originally appeared on Investment U