In the early 1990s, Eugene Fama of the University of Chicago and Kenneth French of Dartmouth caused a stir with research on long-term stock performance.

Analyzing data back to 1926, the two academics concluded that small stocks had outdone large ones and value topped growth. Based on the findings, it appeared investors could beat the S&P 500 simply by holding small value stocks.

Those who acted on the research have not been disappointed. During the 15 years ending in December, small value funds returned 7.7% annually, more than 1 percentage point better than the S&P 500, according to Morningstar.

The results may encourage investors to overweight small value now. But that could be a mistake. Having outperformed in recent years, small caps are not cheap compared to large caps. The price-to-earnings ratio of small value funds is 11.1, compared with 10.5 for large value.

In addition, small stocks can be volatile, sometimes recording steep falls. To appreciate the hazards that today's markets could present, consider how small stocks performed during the Great Depression. In 1929, large caps dropped 8.4%, while small issues fell 51.4%, according to Ibbotson Associates. The next year, small stocks gave up another 38.2%, more than 14 percentage points worse than large caps. While small stocks of all kinds suffered, the damage was particularly severe for small value stocks, says Ben Inker, director of asset allocation for money manager

GMO

. "Many small value stocks are junky," says Inker. "In really bad economic times, they go bust in disproportionate numbers."

Should you shun small value funds altogether? Not necessarily. Small value funds can be effective diversifiers that sometimes rise when other investments fall.

To avoid trouble, hold only limited small value positions and stick with funds that proved resilient in last year's downturn. Many of the best recent performers focus on solid stocks, steering away from shakier issues.

A strong choice is

Heartland Value Plus

(HRVIX) - Get Report

, which lost 17.9% in 2008, outdoing the S&P 500 by 19 percentage points. During the past 10 years, the fund has returned 7.9% annually, more than nine percentage points better than the S&P 500.

Heartland aims to give shareholders the benefits of small value stocks while limiting the risks. Portfolio manager Michael Petroff focuses on financially sound companies with little debt. A diehard value investor, he only takes stocks with below-average price-to-earnings ratios. Such out-of-favor companies may be facing temporary problems. But Petroff prefers businesses that are recovering, reporting improving earnings. "Our companies have sound business models that are likely to produce better results in the future," he says.

A favorite holding is

Triumph Group

(TGI) - Get Report

, a maker of spare parts for airlines. While the business is profitable, the shares sell for a modest price-to-earnings ratio of 8.5.

Another solid performer is

Evergreen Special Values

(ESPAX) - Get Report

, which returned 6.3% annually during the past 10 years. Portfolio manager Jim Tringas seeks stocks of companies with little debt and steady cash flow. "We steer away from companies that have to finance big capital expenditures," he says.

Many of the fund's holdings are workhorse industrial businesses with firm grips on market niches. A top holding is

Mueller Industries

(MLI) - Get Report

, which makes pipes and valves used in air-conditioning systems. "The company is a low-cost producer that controls a big share of its market," says Tringas.

For a mix of growth and value stocks, consider

Natixis Vaughan Nelson Small Cap Value

(NEFJX) - Get Report

. To spot value names, portfolio manager Chris Wallis looks for stocks that sell for half the value of the assets. Among growth names, he seeks companies with strong competitive advantages. Because the portfolio is diversified, it can thrive in a variety of market conditions. In 2008, the fund outdid the S&P 500 by 15.9 percentage points. A big holding is

Pactiv

(PTV)

, the maker of Hefty plastic bags. "Pactiv is a high-return business with predictable revenue," says Wallis.

Such profitable companies could help the top small value funds continue delivering competitive returns in difficult markets.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.