Playing Small-Caps In This Market? The Key Is Dividends

By Aaron Levitt | September 02, 2014 AAA

As the market surges ever-higher, investors have begun to wonder just how much more altitude it has in it before it stalls. We’ve seen roughly five-straight years of gains since the depths of the recession so it’s understandable that investors are getting a bit nervous. To that end, they’ve begun to shun many risk assets.

And lately, that means many small-cap stocks. (For more on investing in small-caps, see Small Caps Boast Big Advantages).

Dividends Are Key

As the “risk-off” trade has once again crept back into investors’ minds, high-growth and high-priced stocks have been sold off. This includes small-caps; the sector has fallen behind their larger brethren in terms of performance. The segment benchmark – the iShares Russell 2000 ETF (IWM) – has dropped about 4.3% year-to-date, while the S&P 600 has fallen 3.3%. Meanwhile, the large-cap S&P 500 has gained about 3%.

And given some of the headwinds facing the economy, some analysts predict that small-cap volatility should persist throughout the year. When viewed over the long term, however, the historical outperformance of small-caps shouldn’t be ignored, largely because they offer the cushion of dividends.

In the current sell-off, we’ve already begun to see the power of dividends in the small-cap space. The Russell 2000 Value Index, which features many small-cap dividend payers, is down only 2.7% year-to-date.

Conventional wisdom dictates that small companies need to reinvest every last penny into their businesses in order to fund growth. But just as in the large-cap world, dividends in the small-cap space point to steady cash flows, low debt and overall financial discipline. And those dividends can point to longer-term outperformance, as well. Between 1993 and 2011, the average annual total return for the Russell was 10.1% for those small-cap firms that paid dividends. That compares to just a 6.2% for those that do not, and an 8% return for the entire index.

How to Add a Dose of Small-Cap Dividends

For investors looking to add some small-cap dividend muscle to their portfolios, there are a few ways to gain exposure. And with rocky days ahead, the time to do that could be now. To that end, ETF issuers WisdomTree Investments Inc. (WETF) offers several products to gain exposure. The biggest of which is the $1 billion WisdomTree SmallCap Dividend Fund (DES).

DES offers investors a broad starting point for getting some yield out of smaller firms. The ETF tracks 685 different small-cap dividend payers, including cigarette maker Vector Group Ltd. (VGR) and salt miner Compass Minerals International Inc. (CMP). DES currently yields 2.85%. That focus on dividends has the ETF returning a whopping 80% since its inception in 2006. Another interesting fund from WisdomTree is its new WisdomTree U.S. SmallCap Dividend Growth Fund (DGRS). The idea is similar, except DGRS screens for those firms that have consequently grown their dividends, rather than just focusing on yield.

Another potential option is to focus on value stocks within the small-cap space. The iShares Russell 2000 Value (IWN) and iShares S&P Small-Cap 600 Value (IJS) track the previously mentioned value versions of their parent indexes. Both yield more and have held up better in the wake of rout. Another option could be the PowerShares S&P SmallCap Low Volatility (XSLV). XSLV tracks the 120 stocks within the S&P 600 with the lowest realized volatility over the past 12 months. That also boosts the dividend yield of XSLV to 2.36%.

Finally, as with large-caps, certain sectors generally pay more than others. Small-cap utilities can be a fertile hunting ground for dividend seekers. Diversified power producer Otter Tail Corp. (OTTR) currently yields 4.3%, while water utility American States Water Co. (AWR) yields 2.9%. (For more on small-cap investing basics, see An Introduction to Small Cap Stocks)

The Bottom Line

Small-cap stocks have taken a beating at the hands of jittery investors. But there are opportunities if you focus on dividend-paying companies. Fortunately, there are several strategies to get exposure to dividend-paying small-cap stocks, including ETFs and sector-specific plays.

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