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 such as PepsiCo (NYSE: PEP) and H.J. Heinz (NYSE: HNZ) 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.

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 -- Actuant (NYSE: ATU) and Brown & Brown (NYSE: BRO)  more than doubled during the period.

Bull riding
Yet even more impressive is that these small-cap dividend payers also outperform in bull markets. Of those 721 small-cap dividend-paying stocks from 2000, about 35% have gone on to more than double since March 2003, including Cummins (NYSE: CMI) and U.S. Steel (NYSE: X).

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 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 $229 billion and $23 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 25 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 does not hold shares in any company mentioned. Wal-Mart is a Motley Fool Inside Value pick, Actuant is a Hidden Gems pick, and H.J. Heinz is an Income Investor recommendation. The Fool's disclosure policy pays dividends daily.