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Small-Cap Investing and Dividends

When investors think about investing in small-cap stocks, dividend payments usually aren’t the first thing that comes to mind.

Small-cap stocks are for aggressive investors and usually come with a higher-than-average degree of volatility – it’s not the type of stock that income investors consider when they look for dividend payers. But research shows that dividend-paying small-cap stocks can be worthy contenders for your investment portfolios.

According to Royce Research, dividend-paying stocks in the Russel 2000 Index (an index comprised of small-cap stocks) achieved an average annual return of 10.5% between 1993 and 2015. Non-dividend payers only managed 7.5% – less than the Russel 2000 total return of 8.8%. What’s more is that dividend-paying stocks had a standard deviation of 14.8 compared to non-dividend payers and the Russell 2000 at 23.8 and 19.2, respectively, which made them less volatile as well.

It may seem counter-intuitive, but screening for dividend-paying small-cap stocks appears to be a more profitable approach that could also reduce your portfolio’s overall risk profile.

How Well Do Small-Cap Stocks Perform?

Ideally, small-cap stocks should be the biggest gainers in a stock portfolio. Their small size can translate into large annual growth that can exceed 100% year-over-year in some cases. The opportunities for growth are more abundant for a $800 million company that operates regionally than an $80 billion company that has operations across the globe.

Looking at past performances sheds some insight on how small-cap dividend-paying and non-dividend-paying stocks perform during bearish and bullish market conditions.

A table from Royce Research compared dividend payers and non-dividend payers in the Russell 2000 based on their performance in bear markets by measuring returns from the peak stock price to the bottom. Unsurprisingly, dividend payers won out here with an average loss of -9.6% compared to a gut-wrenching loss of -39.2%.

Measuring performance from the bottom to the top yielded a different result, however. In most cases, non-dividend-paying stocks tended to return higher percentages than dividend-paying stocks, which is what one would expect to see. It should be noted that even during market upswings, dividend-paying small-cap stocks did outperform non-dividend-paying ones in at least one bull market period.

Finally, a measurement of performance from the peak of one bull market to the peak of the next one showed a clear advantage for dividend-paying small-cap stocks over non-dividend-paying stocks. For the five bull markets that were taken into account, dividend payers averaged a gain of 63.5% compared to 29.6% for non-dividend payers while the Russell 2000 index as a whole managed 36.1%.

Use the Dividend Screener to find high-quality dividend stocks including small-cap equities. You can even screen stocks with our proprietary DARS ratings above a certain threshold.

The Ups and Downs of Small-Cap Stocks

As with any investment, small-cap stocks have positive and negative qualities. The potential upside might be relatively high compared to mid-cap or large-cap stocks, but so are the risks. Investors should carefully weigh the pros and cons of small-cap stocks and understand their risk tolerance before investing.

One of the advantages that small-cap stocks tend to have over large-cap stocks is that they typically have limited analyst coverage, giving investors an opportunity to find valuation discrepancies. A stock that isn’t widely followed might not be trading at its intrinsic value compared to more popular stocks that have its financial statements poured over repeatedly by analysts and are unlikely to be mispriced.

Small-cap stocks are by nature more volatile than large-cap companies, however. They are subject to greater price swings and will usually outperform or under-perform the broader averages day-to-day. This effect can be seen in a small-cap stock’s beta – almost always over 1. While a rating of 1 means that the stock performs in line with markets, a bigger number means that the performance of the stock will be exaggerated compared to the broader indexes. For example, a beta of 2 means that the stock tends to have double the percentage gain or loss on a daily basis than the broader averages like the S&P 500.

The other downside to dividend payments in a small-cap stock is the company’s ability to continue paying it. A stock that pays out earnings as dividends means that it isn’t using that money to invest in new opportunities and boost its growth prospects. A company that lacks growth is likely a company that won’t be able to sustain a positive bottom line.

For more investment concepts, visit our Dividend Investing Ideas Center.

The Bottom Line

Investing in small-cap stocks and receiving a dividend payment doesn’t have to be two separate considerations. Dividend payments boost net returns over time and generate more consistent annual portfolio performance. The dividend also helps minimize volatility by generating a constant return that can help offset downside movements.

Finally, investors should keep in mind the golden rule of investing – diversification. Keeping a mix of small-cap, mid-cap, and large-cap stocks in a portfolio is the best defense against non-systemic risks.

And be sure to visit our complete recommended list of the Best Dividend Stocks so you know where to look to find the biggest profit-making opportunities!