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 was 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 such as UPS (NYSE:UPS) and ConocoPhillips (NYSE:COP) were down significantly less during this period.

With 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% 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 in this bunch -- New York Community Bancorp (NYSE:NYB) and XTO Energy (NYSE:XTO) each 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 those 721 small-cap dividend-paying stocks from 2000, 40% have gone on to more than double since March 2003. Included in this group are Chicago Bridge & Iron (NYSE:CBI) and Toro (NYSE:TTC).

But perhaps there's more to the success of these companies than just paying dividends. As my colleague Rex Moore has pointed out, a small company's act of paying a dividend not only reflects management's long-range visibility on profits, it 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 $180 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. Fool co-founder Tom Gardner and his Motley Fool Hidden Gems team have used these attributes to find small-cap stocks -- and they've served the team well. Cumulatively, their picks are beating the market by more than 30 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.

Fool contributor Todd Wenning 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.