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Why Invest in Small-Cap Dividend Growth Stocks? Hint: It’s All About Quality

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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

Small cap dividend growers-1

Small cap dividend growers-2

(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.

Small cap dividend growers delivered higher return on equity…without sacrificing the growth

Small cap dividend growers-3

How does one define quality? One widely used measure is return on equity (ROE). ROE shows how profitable a company is by comparing net income to average shareholders’ equity. The higher the ROE, the more efficient management is in using its equity base and the greater the return to investors. As shown below, small cap companies that grew dividends delivered higher ROE than other small caps, and they did so without sacrificing growth.

(Source: Russell Investment Group. Return on Equity (ROE) is based on the 5-year average for the period ending 12/31/2014. Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock; it serves as an indicator of a company’s profitability. Here, EPS is calculated for the last 10 years ending 12/31/2014.)

Important takeaways

The benefits of a dividend strategy don’t apply exclusively to U.S. large cap stocks.

  • Applying a dividend growth strategy to your small cap stocks can potentially deliver the strong performance of small cap investing with lower levels of risk.
  • The key is in the quality. Companies that grow their dividends have stronger quality profiles—earnings and balance sheets—without sacrificing the growth potential that makes small caps so compelling.

Bottom line: A risk-measured small cap dividend growth strategy may be well timed for today’s market environment of high stock valuations and low bond yields.

Learn more

Visit to learn more about the appeal dividend growth investing. This article and additional reports on dividend growth investing are available in the Resources section.

  1. Source: Morningstar
  2. Source: Ned Davis Research


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