Small companies typically outperform over time because they have greater growth prospects than the market leaders. 

Between 1927 and 2012, for instance, small caps produced annual returns of 12.9%, compared with 9.9% for large companies. Even now, when many indices have hit highs, the S&P 600 Small Cap Index has gained 31%, in the past year compared with a 23% gain for the S&P 500 over the same period.

#-ad_banner-#But most retail investors shy away from small caps mainly because they perceive them to be part of the seedy underbelly of investing, the world of pump-and-dump boiler rooms. That reputation is not entirely undeserved. Many illiquid companies exist whose financials are at best an educated guess. 

So to find small-cap stocks that could be assumed to be reasonably safe investments, I used a several-step screening process, starting with solid fundamentals and substantial insider and institutional ownership. 

Among companies with market caps of no more than $90 million, I found 23 that had positive returns on equity and assets, a forward price-to-earnings (P/E) ratio, and institutional and insider ownership of at least 10%.

*of those with dividends

I compared the one-year returns of these stocks with the S&P 600 Small Cap Index. Any stock that had crossed below the index and was trending down was dropped, which left me with six contenders — three of which paid dividends. Like many investors, I have a bias toward stocks that pay dividends, so let’s look at those.

What I found were three companies which each have been on a solid growth trajectory.

Acme United (NYSE: ACU) is a global supplier of cutting, measuring and safety products to consumer and industrial markets. It has neatly tracked the S&P small-cap index and shown the least volatility of the three stocks. While its $43.7 million market cap is the lowest of the three, its nearly $14 share price is the highest. It has a forward P/E of 9.2, and its dividend yield is the best of the three at 2.3%. In its most recent quarter, Acme posted a 7% increase in net income and a 3% rise in earnings.

On the institutional side, North Star Investment holds nearly 400,000 shares and has made more than a dozen insider purchases this year. Acme’s CEO, Walter Johnson, did sell 8,000 shares this month, but he still holds more than 350,000 shares.

Eastern Virginia Bankshares (Nasdaq: EVBS) is a bank holding company. It received $24 million in financial bailout funds, but it’s been released from its agreement with regulators because it raised enough money through private placement. Its $66.7 million market cap puts it in the middle of the group, although its share price is currently the lowest at just over $6. It has a forward P/E of 9.2, but its 1.1% dividend yield is the least of the three. Net income and earnings were down for the most recent quarter, mainly on charge-offs for non-performing and uncollectible assets and other losses.

EVBS’ management and directors have been on a spree buying back stock this year, including 19 transactions in June alone at $4.55 a share — nicely timed before the company said it had been released from its Troubled Asset Relief Program (TARP).

Pzena Investment Management (NYSE: PZN) is an investment manager catering to wealthy families and other institutions. It has the largest market cap at $85.4 million, and its share price, although the highest at about $7, buys the most market cap per dollar of the three. It has a forward P/E of 14 and a dividend yield of 1.7%. For the most recent quarter, revenue grew 5.4% and earnings were flat. Although Pzena’s gross profit margin was down from the previous year, it remains a very high 45.2%.

Top holders include Fine Capital, with nearly a quarter of a million shares, and Renaissance Technologies, with about 125,000 shares. Renaissance’s bet on PZN is interesting because it usually is heavily invested in large caps.

Risks to consider: Neither past performance nor insider or institutional investment is a guarantee of future success.

Action to Take –> Together, these three stocks are quite promising. Due to the heavier institutional investment, I give PZN a slight edge over ACU. EVBS still has a way to go to prove itself, but now that it’s free of the bailout program, it could really blossom.

P.S. — Investors’ expectations for small-cap stocks often stem from expectations of future growth — and if you’re interested in growth, you should read our latest report, “The 11 Most Shocking Investment Predictions For 2014.” You’ll find out about the tiny company that could kill the gasoline engine and the little-known soda company that could mean big trouble for Coca-Cola and Pepsi. Click here to find out more.