Great Stocks to Own in Any Market

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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 iShares Russell 2000 Growth ETF 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 United Parcel Service (NYSE: UPS), Weyerhaeuser (NYSE: WY), and ConocoPhillips 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:

Category	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	1,022	27%	(26%)

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, 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 -- Hudson City Bancorp (Nasdaq: HCBK), Toro (NYSE: TTC), and XTO Energy (NYSE: XTO) all more than doubled during the period.

Bull riding
Even more impressively, these small-cap dividend payers also outperform in bull markets. Of those 721 small-cap dividend-paying stocks from 2000, a good number have gone on to more than double since March 2003, including Albemarle (NYSE: ALB) and CONSOL Energy (NYSE: CNX).

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

Two oft-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 led by innovative and engaged founders. Today, these companies are valued at $225 billion and $22 billion, respectively, and they've both made early investors quite wealthy.

What to look for
There are certainly other attributes beyond dividends to look for in quality small-cap companies, but as you can see from this data, a healthy payout is 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. The Motley Fool Hidden Gems team has successfully used these attributes to find great small-cap stocks. Cumulatively, its picks are beating the market by 23 percentage points since the newsletter began in 2003.

If you're looking for 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 celebrates life's small victories with an Irish jig, but does not hold shares in any company mentioned. United Parcel Service is a Motley Fool Income Investor pick. Wal-Mart is an Inside Value recommendation. The Fool's disclosure policy pays dividends daily.