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

Or 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. Large stalwarts such as UPS (NYSE:UPS), Weyerhauser (NYSE:WY), and ConocoPhillips (NYSE:COP) 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

% of Companies
With Positive Returns


Large Cap, Paid Dividend




Large Cap, No Dividend




Small Cap, Paid Dividend




Small Cap, No Dividend




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

As the table shows, of the 721 dividend-paying stocks capitalized between $100 million and $2 billion in August 2000, fully 64% 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. W Holding (NYSE:WHI), New York Community Bancorp (NYSE:NYB), Thornburg Mortgage (NYSE:TMA), and XTO Energy (NYSE:XTO) 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 paying 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 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 helmed by innovative and engaged founders. Today, these companies are valued at $183 billion and $25 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. Fool co-founder Tom Gardner and his Motley Fool Hidden Gems team have used these attributes to find small-caps stocks -- and they've served the team well. Cumulatively, their picks are beating the market by more than 37 percentage points since inception 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.

If it's Friday night, Fool contributor Todd Wenning is playing at the Pinecone Inn. He does not hold shares in any company mentioned. Wal-Mart is a Motley Fool Inside Value pick. UPS is an Income Investor choice. The Fool's disclosure policy pays dividends on the daily.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.