From the April 2009 issue of Wealth Manager Web • Subscribe!

April 1, 2009

Small-Cap Dividends

Some financial advisors have long overweighted small value funds, heeding research by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth. In the early 1990s, the two academics concluded that over long periods, small stocks had outperformed large ones and value had topped growth.

The recent market collapse has upended many investing theories, but the work of Fama and French remains intact. During the decade ending in December, small value funds returned 5.5% annually--nearly seven percentage points ahead of the S&P 500 index and eight points ahead of large growth.

Whether or not they continue to outperform, small value funds are worth holding for diversification. The funds often beat the S&P 500 during downturns. In the down years of 2000 and 2001, small value funds stayed in the black. During 2008, every stock fund category was crushed, but small value managed to edge out the S&P 500 by two percentage points.

Which small value fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by FI360, a consulting firm in Sewickley, Pa. FI360's due diligence process seeks funds that have more than $75 million under management and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass the medians. The expense ratio must fall below the top quartile, and at least 80% of the fund's holdings must be consistent with the category.

The screens reduced the field from 394 funds to 58. Top performers included Columbia Small Cap Value I and Franklin Small Cap Value. But we awarded the title to Allianz NFJ Small Cap Value, which had the highest five-year returns of the group and one of the best alphas.

Allianz portfolio manager Paul Magnuson has delivered steady results by following a rigid discipline. For starters, he only takes shares that pay dividends. Among small-cap funds, the strategy is unusual.

While many large-cap funds focus on dividend stocks, most small-cap funds take at least some non-dividend payers. Portfolio managers figure that small companies should reinvest their earnings in order to grow--instead of paying cash out to shareholders. But Magnuson says that dividend-paying small companies tend to be stable businesses with healthy cash flows. That helps to explain why dividend-paying small stocks have outperformed nondividend payers over long periods. In addition, dividend payers often lose less in downturns.

Magnuson says that dividend yields became increasingly attractive in recent months as markets declined. When share prices fall, dividend yields rise. Many small-cap dividend stocks currently yield more than 4%, and the yield on the Allianz fund is 1.9%--a rich payout at a time when two-year Treasury bills yield less than 1%. "As the population ages, more people will be looking for income, and they will turn to dividend stocks," he says.

Besides insisting on dividends, Magnuson only takes companies with earnings. Unprofitable businesses could collapse suddenly, he says. "We are not interested in companies where the earnings are supposed to come through some time in the future."

A diehard value investor, Magnuson focuses on stocks that have below-average price-earnings ratios based on earnings for the coming year. The current average multiple is 11.3, which is the forward P/E ratio of the Russell 2000.

Searching for bargains, Magnuson likes to buy stocks that are declining, but he is wary of shares that seem to be in free fall. To avoid the worst losers, he tracks the price performance of stocks and divides the universe of small stocks into deciles.

If a portfolio holding ranks in the bottom decile--which means it is among the market's worst performers--he sells the shares. He does not buy any stocks that are in the ninth or 10th deciles. "If the stock is doing poorly, there could be problems that we have not recognized yet," he says.

Magnuson favors companies with strong balance sheets and healthy cash flows. He is particularly keen on energy companies, which account for about 15% of the portfolio's assets. Whether or not oil prices rise, many energy producers are cheap and pay solid dividends, says Magnuson. A favorite holding is Cimarex Energy, an oil and gas producer. Although the stock has a skimpy P/E of 7, the company has little debt and more than $2 per share in cash.

Another energy holding is Tidewater, which supplies services to offshore drilling operations. Even though the company's sales and earnings have been growing, the shares sell for a P/E of 5. The stock has a dividend yield of 2.6%.

About 10% of assets are in utilities, which have long been known for their hefty dividends. A top holding is AGL Resources, an Atlanta gas provider that has a dividend yield of 5.4%.

To limit risk, the Allianz portfolio is broadly diversified, including more than 100 stocks. No one name may account for more than 1.5% of assets. The fund holds stocks in each major industry, but Magnuson doesn't necessarily match the weightings of his benchmarks. Because many health and technology companies do not pay dividends, the fund is underweight those industries. While the Russell 2000 has 16% of its weight in technology, Allianz holds only 4% of the portfolio there.

By staying diversified and sticking with solid stocks, Magnuson hopes to limit losses in downturns and enable shareholders to achieve steady long-term returns.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a regular contributor to Wealth Manager.

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