Look beyond large caps for dividends and higher returns
In today’s yield-starved environment, income investors are turning to dividend-paying stocks to supplement the income streams fixed income investments have historically provided. But dividend strategies are traditionally expressed—knowingly or unknowingly—through the lens of U.S. large cap equities. After all, there are roughly twice as many dividend-paying stocks in the large cap space as in the small cap space. So it’s logical that most dividend-themed products in the marketplace focus on large caps.
Small cap investing, however, is a core strategy for many investors—both for enhancing diversification and pursuing potentially higher returns. Indeed, since 1926, small cap stocks have outperformed large caps on a nominal basis by approximately 200 basis points annualized.1 But there’s been a downside to those returns—they’ve come with greater risk.
Manage the risk in small caps with a dividend growth strategy
So, can you exploit the return potential of small caps without the punishing drawdowns and volatility? The answer may be found in a dividend strategy. In recent years, companies that paid dividends have outperformed those that didn’t. But not all dividend strategies are equal. As a group, companies that have grown their dividends have outperformed other dividend payers—and by a wide margin.2 This simple but powerful investing principle applies not only to U.S. large cap equities, where it is already widely embraced, but to U.S. small caps too.
Small cap dividend growers generated greater returns with less volatility
January 31, 1987—December 31, 2014
(Source: Ned Davis Research analysis reflecting the performance of groups of companies underlying the Russell 2000 Index, a measure of the U.S. small cap equity market. Data is from January 31, 1987 through December 31, 2014. Past performance does not guarantee future results. “Annualized Volatility” refers to standard deviation, a statistical measure that captures the variations from the mean of a stock’s returns and that is often used to quantify risk over a specific time period. The higher the volatility, the more the returns fluctuate over time.)
What’s behind small cap dividend growth’s historical outperformance? Quality
Much of the difference in return potential between small cap dividend growers and other small cap stocks can be attributed to lower historical risk. Not only have small cap dividend growers had lower volatility compared with the overall small cap space, they also have had lower drawdowns. In “winning by not losing as much,” they have achieved better returns over time. When looking at the attributes of small cap companies that have grown their dividends, it becomes clear: You can get higher quality companies without giving up their growth potential.