It’s no secret that over the longer term, small-caps have managed to eat larger stocks lunch in terms of returns. For those investors with long time horizons — and who can stomach some volatility — broad small-cap indexes like the iShares Russell 2000 (IWM) have been a great way to find growth. However, investors may want to take another look at small-caps through a slightly different lens, namely one that’s tinted towards income.

Small-caps are turning into some pretty big dividend payers.

The idea of smaller firms paying out some hefty cash as dividends highlights and enhances their appeal in a portfolio. For investors, the time to think of small-caps as something more than just a capital gains play is at hand. (For related reading, see: Playing Small-Caps in this Market? The Key is Dividends.)

Big Boost in Small-Cap Dividends

For most people, conventional wisdom holds that small companies need every cent they make in order to keep the growth coming. That simply isn’t true. Market capitalization isn’t indicative to how a company is run or what kind of profits it generates. Dividends in the small-cap space — just as they do across the market cap spectrum — point to steady and rising cash flows, low debt and overall financial discipline. (For related reading, see: An Introduction to Small-Cap Stocks and Small Caps Are for Dividends Too.)

And more and more small-caps “fit” within that category. (For more on this topic, see: Small Caps Boast Big Advantages.)

According to S&P Dow Jones Indices analyst Howard Silverblatt, the S&P SmallCap 600 has seen a 10.2% increase in the number of firm’s that pay dividends over the last year. Over the last 20 years, the index has seen a 22.3% rise in the number of dividend issues. That compares to a 3.4% decline for large-cap stocks. Currently, 324 of the 600 companies in the small-cap index pay out a dividend now. The percentage of small-cap dividend payers is only tad behind that of large-caps in the S&P 500, but already outpaces mid-caps in the S&P 400 by over 12 basis points.

That’s pretty impressive on its own. However, the real win could be dividend growth in the small-cap sector.  (For more, see: Small Cap Research Can Have a Big Impact.)

The headline yield on the S&P 600 is only about 1.3%. But that could be changing. Small-caps have bested their larger rivals in terms of just how much cash they are handing out to shareholders since the end of 2013, small-caps in the index have increased their dividends by 16.54%. And there could be more room for higher payouts ahead.

Payout ratios for small-caps remain low. According to S&P Dow Jones Indices, only 182 dividend payers have a dividend rate less than 50% of their 12 month net GAAP income. Roughly 235 stocks have a payout rate of less than 75%. That means, many small-cap firms are still earning well above what they pay-out in dividends. Essentially, freeing their boards and management to pay-out more cash back to shareholders. In fact, Silverblatt estimates that 202 stocks in the index will pay more in the future than they paid in 2014.

Ways to Play the Dividend Payers

Given the opportunity in dividend-paying small-caps, investors may want to tilt their portfolios into that direction. And given the growth in dividends for the S&P 600, the index — and fund that track it, such as the iShares Core S&P Small-Cap (IJR) — may turn out to be great income plays over the longer haul. However, there are ways to isolate the dividend component of the index and small-cap stocks today.  

A good starting point could be the WisdomTree SmallCap Dividend ETF (DES). DES tracks a priority index that use various screens to choose the best dividend payers and then weights them accordingly to the aggregate cash dividend each firm is projected to pay in the coming year. Currently, DES holds 728 stocks. Top holdings for the ETF include cigarette manufacturer Vector Group Ltd. (VGR) and shipping container owner/leaser TAL International Group, Inc. (TAL). DES currently yields 3.34%. More importantly, that focus on dividends helps underscore the “why” small-cap dividends can be great for a portfolio. The ETF has managed to return a whopping 94.35% since its inception in 2006. (For more, see: Trade U.S. Small-Caps with this ETF.)

As we’ve said before, the real highlight for small-caps could be their continued dividend growth. The newly launched the newly minted ProShares Russell 2000 Dividend Growers ETF (SMDV) could be a great pick. The ETF follows stocks within the Russell 2000 that have increase their dividends for at least for a decade straight. As you expect, SMDV is a pretty concentrated portfolio, currently holding only 55 different small-cap dividend champions. For those looking for slightly less stringent dividend growth rules, the WisdomTree U.S. SmallCap Dividend Growth Fund (DGRS) features a wider swath of dividend growers.

Finally, as with large- and mid-caps, certain sectors and styles of stocks pay more in dividends to begin with. The PowerShares S&P SmallCap Utilities Portfolio (PSCU) tracks a basket of small-cap utilities, while the Vanguard Small-Cap Value ETF (VBR) focuses on “value” equities. Both have been traditionally higher yielding sub-sectors of the market. The ETFs yield 2.61% and 1.91%, respectively. (For more, see: The PowerShares S&P SmallCap Utilities ETF.)

The Bottom Line

For investors, small-caps shouldn’t be just about growth. They can be powerful income tools as well. The continued growth in the number of small-cap dividend payers as well as increases to their payouts are a welcome sign and underscore how they’ll continue to outperform their larger rivals into the future. (For more, see: Which ETF to Choose: Small Cap vs. Large Cap.)

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