Even though they provide the market's best returns over the long run, small-cap stocks get rattled hard during bear markets.

Or, at least, so the theory goes.

For example, the iSharesRussell 2000 Growth exchange-traded fund got cut in half between August 2000 and March 2003. Yet the large-cap-laden S&P 500 didn't do much better, losing 42% of its value. Larger stalwarts like Dow Chemical (NYSE:DOW) and Colgate-Palmolive (NYSE:CL) were down significantly less during this period.

Based on this data, one might assume that investors should buy large caps to ride out the storm during bear markets.

To the contrary
There was, however, a better way to preserve your capital and even profit during this brutal bear market: by buying small-cap dividend payers. Take a look:

No. of
Companies

% of Companies
With Positive Returns

Average
Return

Large cap, paid dividend

157

25%

(27%)

Large cap, no dividend

73

4%

(70%)

Small cap, paid dividend

721

64%

20%

Small cap, no dividend

1056

24%

(29%)
*Price data courtesy of Capital IQ. Returns from Aug. 14, 2000, to March 15, 2003.

Seriously?
As the table shows, of the 721 dividend-paying stocks capitalized between $100 million and $2 billion in August 2000, fully 64% of them stayed in the black during this turbulent period. What's more, the average return of the group was 20%.

And there were certainly some great growth opportunities to be found in this bunch -- WSFS Financial (NASDAQ:WSFS), Strayer Education (NASDAQ:STRA), Omnicare (NYSE:OCR), and Applebee's (NASDAQ:APPB) all more than doubled during the period.

Bull riding
Yet even more impressive is that these small-cap dividend payers also do well in bull markets. Of the aforementioned 721 small-cap dividend-paying stocks from 2000, 40% have gone on to more than double since March 2003.

But perhaps there's more to the success of these companies than just their paying of dividends. As my colleague Rex Moore has pointed out in the past, a small company's act of paying a dividend not only reflects management's long-range visibility on profits but also shows a commitment to partnering with shareholders.

Two often-noted success stories that reflect this philosophy are Wal-Mart and Automatic Data Processing. Both companies paid dividends when they were small, and both were helmed by innovative and engaged founders. Today, these companies are valued at $191 billion and $26 billion, respectively, and have made early investors quite wealthy.

What to look for
There are certainly other attributes to look for in quality small-cap companies besides dividends, but as you can see from this data, it's a good place to start.

Other things to hunt for include strong management (perhaps with a founder/CEO), solid balance sheets, and plenty of room to grow. Those attributes are what Fool co-founder Tom Gardner and his Motley Fool Hidden Gems team have used to find small-cap stocks -- and they've served the team well. Cumulatively, their picks are beating the market by more than 32 percentage points since inception in 2003.

If you're interested in finding some quality stocks to add to your portfolio, consider a free full-access, 30-day trial to Hidden Gems. There is no obligation to subscribe. Simply follow this link for more information.

This article was originally published on Jan. 12, 2007. It has been updated.

Todd Wenning does not hold shares in any company mentioned. Wal-Mart, Omnicare, and Colgate-Palmolive are Motley Fool Inside Value picks. Dow is an Income Investor choice. The Fool's disclosure policy pays dividends on the daily.