Look Towards Small-Caps For Big Dividends

By Aaron Levitt | May 22, 2013 AAA

With the market reaching new highs every day, many investors have begun to get a little worried about its immediate future prospects. As such, they have been turning their attentions back towards dividend investing. Exchange-traded funds (ETFs) such as the iShares High Dividend Equity (ARCA:HDV) -which tracks a broad-basket of dividend paying companies- have become immensely popular with investors as they seek income and safety.

However, in that search for strong yields, many investors have tilted their portfolios towards the high dividends and long track records of the market's largest firms. Conversely, some of the best opportunities for dividend hunters could lie within the smaller side of the stock market.

SEE: An Introduction To Small Cap Stocks

Big Yields In Small Places
Generally, when investors look towards small-cap stocks, they do so from a vantage point of growth and capital appreciation. After all, the iShares Russell 2000 Index (ARCA:IWM) has been a top long-term performer over the last few decades. Additionally, there have been many academic studies that show that small-caps outperform larger ones over the years.

Yet, when it comes to dividends investors often ignore their potential.

That’s a real shame as many companies within the small-cap universe are just as diligent at paying out income as say, Procter & Gamble (NYSE:PG) or Chevron (NYSE:CVX). General consensus is that small companies need to plow every available penny back into the business in order to fund their growth. That’s generally true as roughly 20% of the Russell 2000 are unprofitable companies. However, just as in the large-cap world, dividends in the small space show financial discipline, often steady cash flows and low debt. These added dividends have many positive effects, including lower volatility and perhaps most important of all -higher returns.

When comparing dividend paying small caps in the Russell 2000 to those who do not pay, the dividend payers beat their non-paying twins by a large percentage. From December 31st of 1984 through the first quarter of this year, dividend-paying members of the small-cap benchmark outperformed the non-dividend payers by 2.6% points annually. That’s enough extra “oomph” to produce some serious gains over the long haul.

SEE: How To Live Off Your Dividends

Additionally, despite an abundance of small-cap companies that pay dividends, very few institutional managers focus on dividends within the small-cap universe. That can provide plenty of yield and growth opportunities for retail investors looking for ignored bargains.

How To Think Small

Given the potential for outperformance and juicy yields, investors should consider the small-cap space for dividend payers. For those looking for single ticker access to dividend-focused small-caps, ETF issuer WisdomTree (NASDAQ:WETF) has the most exposure to the theme. The WisdomTree SmallCap Dividend ETF (ARCA:DES) tracks 642 different firms including imaging firm Lexmark (NYSE:LXK) and utility ALLETE (NYSE:ALE). Over the past five years, DES has managed to return 8.9% annually versus 7.7% for the previously mentioned IWM. Expenses run a cheap 0.38% and DES yields 2.99%.

The ETF sponsor also offers investors a chance to go global within the small-cap dividend space. Both the WisdomTree International SmallCap Dividend (ARCA:DLS) and WisdomTree Emerging Markets SmallCap Dividend (ARCA:DGS) allow investors to play developed and developing nation’s stocks. The funds yield 3.37% and 2.85%, respectively.

Finally, given the disparity between share prices and actually value that exists in the small-cap space, some active management might make sense in the sector. Asset manager Royce Associates strictly focuses on small-cap stocks and makes dividends a top priority when selecting holdings. While, it's not technically a dividend fund, the closed-end fund Royce Value Trust (NYSE:RVT) could make a great small-cap dividend play. The closed-end fund yields 4.8% and many of the fund's holdings either pay dividends or have the ability to. Additionally, the fund currently can be had for a 9.9% discount to its net asset value.

SEE: Why Dividends Matter

The Bottom Line
With the stock markets continuing there surge higher, investors have turned their attention to dividend investing for safety. However, the bulk of that attention has been shifted towards large cap stocks. Equally as compelling are those firms on the smaller end of the scale. Small-caps can be a fruitful place to gain high yields.

At the time of writing, Aaron Levitt did not own shares in any of the companies or funds mentioned in this article.

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