Many may not be well-known or particularly exciting, but small-cap stocks are increasingly getting respect as the way to enjoy big returns and capitalizing on market trends. According to the Russell 2000 Index, small-caps posted an impressive 15.5% during April's rally, marking the second-largest monthly gain in 30 years of available data. Within the small-cap universe, value stocks slightly outperformed growth stocks for the month, but the year-to-date gap continued to favor the Russell 2000 Growth Index (3.8%) over the Russell 2000 Value Index (-6.9%).

Of course, smaller companies can be more vulnerable in devastating bear markets and have significantly underperformed during recessionary times, according to Doug Roberts, founder of Shrewsbury, N.J.-based Channel Capital Research.

The challenge right now is understanding where we are in the contraction cycle that can be so difficult for smaller companies to weather. "We could be a year away." Roberts says. "It could be two years away. It could be six weeks away. You don't know. So this is really a long-term strategy, for an extended period of time."

Therein lies the performance opportunities of small-caps, adds Jonathan Vyorst, co-portfolio manager of the Paradigm Value Fund (PVFAX) and also co-manager of Paradigm Capital Management's institutional small-cap portfolio. "What you saw from October to March was that a lot of smaller companies got hit worse than larger companies and obviously that's the risk of small-cap investing, but what you're seeing right now is precisely because of that [selloff]," Vyorst says. "And as a value investor, my job is to go out and find the bargains," he says.

Higher volatility is a small-cap investment way of life, Vyorst says. But finding companies which are selling cheap tends to provide a margin of safety. "We look for a higher quality of companies within that spectrum so that we have a lot of businesses in our portfolio that are core holdings, that have greater free cash flow or better balance sheets," Vyorst says. He has also seen an uptick in the returns of small companies since March, with the easing of some credit markets.

Vyorst advises assuming that the recession will last at least another year and to look for companies whose cash reserves and balance sheets make them likely to weather a tough market for a sustained period of time.

Both Vyorst and Channel Capital's Roberts agree that small companies remain undervalued. And, it's no surprise that Vyorst advocates a fund-based approach to investing in small-caps.

Meanwhile, Roberts cites the voluminous research needed to successfully choose small-cap companies, as well as the requisite buy-and-hold position to reap the rewards of this market.

In fact, Roberts maps out the differentials between small-cap and large-cap performance from 1928 to 2006 in his book Follow the Fed to Investment Success. Over that period, $10,000 invested in small-caps would equal more than $107 million in 2006, while the same investment in large stocks would be slightly more than $15.5 million. He argues that small stocks outperform when credit is readily available, often when real short-term interest rates are negative and short-term Treasury Bill rates are less than the rate of inflation.

Roberts adds that what is good for small-caps also can be good for other sectors. He advocates looking at gold and Treasury bonds, when market conditions favor small-cap rallies. A recent Channel Capital Research report found that when money is being pumped into the economy by the Fed, gold benefits in the same way that small stocks do. In addition, inflation—a stimulus-driven concern for some investors—tends to be favorable for gold.