Small-Cap Dividend Darlings

By Aaron Levitt | July 09, 2010 AAA

With the market whip-sawing its way back and forth, many investors have been turning their attentions back to dividend investing. ETFs such as the iShares Dow Jones Select Dividend Index (NYSE:DVY), which track a broad-basket of dividend paying companies, have become immensely popular with investors as they seek income as well as safety. Most portfolios looking for dividends will skew towards large cap stocks, but thinking small may be better.
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Small Beats Large
When investors look towards small-cap stocks, they do so from a vantage point of growth. The iShares Russell 2000 Index (NYSE:IWM) has performed flawlessly over the years. Investing a $1,000 in Ibbotson Associates' selection of small cap stocks in 1927 would be worth around $33 million today. A famous study by economists Fama and French concluded that small caps outperformed their large-cap twins by over four percentage points annually from 1956 to 2005.

General consensus is that small companies need to plow every available penny back into the business in order to fund their growth. 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 higher returns through dividend compounding. In addition, small stocks are often the leaders in bullish economic cycles. As fears of current economic malaise still persists, small-cap dividend stocks can pay while you wait out the storm.

What to Look for
Just as with large market capitalization dividend payers, investors testing the waters of the small-cap space should look for quality balance sheets, good free cash flow generation and high returns on capital. These are often hallmarks of value-styled stocks and many of the small-cap dividend leaders fall within that space. Investors may want to take a look at an ETF like the SPDR Dow Jones Small Cap Value (NYSE:DSV) for a starting point for individual stock ideas.

Adding Those Small Payments
There are currently only two broad based ETFs that focus on the small-cap dividend space. The Wisdom Tree Small Cap Dividend (NYSE:DES) and Wisdom Tree International Small Cap Dividend (NYSE:DLS). Both follow a diversified group of dividend paying small caps and yield, 3.67% and 2.61% respectively. For investors wanting to go with individual stocks, here are a few picks.

Kaydon Corporation (NYSE:KDN) is seeing its star rise right along with alternative energy. The company manufactures ball bearings for various industries, but it is seeing great returns from the wind industry. As one of the major suppliers of parts for the wind turbine producers, Kaydon should see increased demand for its bearings, while more major wind products are built out across the globe. Shares of the company yield 2.20%. (Learn more about investing in green tech, see: Clean Or Green Technology Investing.)

Nothing is as fickle as teenagers and their fashion. One minute everyone is wearing Abercrombie & Fitch (NYSE:ANF), the next is something else. As recession worries still plague the headlines kids are getting thriftier, American Eagle Outfitters (NYSE:AEO) is seeing green for its lower priced t-shirts and jeans. Even though AE posted disappointing numbers for same-store sales, the company is confident in its position as a top young adult retailer and recently raised its quarterly payment by a penny. Shares of the firm yield almost 4%.

If the economy is moving towards slower growth, investors may find solace in consumer staples. B&G Foods (NYSE:BGS) is in the boring business as a purveyor of pickles, hot sauce and taco shells. Its Ortega brand is one of the most recognized in its category. The company expects its earnings to rise by 33% through 2010 and recently declared its 23rd consecutive dividend. Shares of B&G yield 6.6%.

Bottom Line
Investors are returning to dividends both as a source of income and to smooth out the markets return to volatility. However, most of their focus is towards larger capitalized stocks. Small-cap dividend payers offer many of the same benefits and shouldn't be ignored in portfolios. The preceding stocks and ETFs are a good place to start a search for small-cap income.

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