From years of experience, I’ve learned that the stronger the run has been, the more likely the run will turn to a limp.
Small-cap stocks have had a strong run. While the S&P 500 Index finished 2013 up nearly 30%, the small-cap S&P 600 finished up nearly 40%. When we look back five years, we see the S&P 500 is up 100%, but the S&P 600 is up 150%.
Five years of 20% average annual compound returns would usually be a put-off. That said, I can’t say I’m put off by small-cap stocks (market cap of $5 billion or less). I still see pockets of value in the segment and opportunities to outperform the overall market in 2014.
First, on a macro level, the S&P 600 Small-Cap Index isn’t unreasonably overpriced. On a forward basis, the index is trading at 18.7 times 2014 Thomson Reuters earnings estimates. Admittedly, that’s a bit on the high side, but not discerningly so.
Within the small-cap realm, I find dividend growers especially appealing. From my own experience, small-cap dividend stocks have been the lead performers in the High Yield Wealth portfolio in the early stages of the new year. I believe they’ll maintain that lead over the next 12 months.
To be sure, large-cap dividend growers have strong performers, but I see them as more vulnerable to institutional selling than small caps. Large-cap stocks are used to soak up institutional money inflows to a greater extent than small-cap stocks. I wouldn’t be surprised if more institutions rotate out of large-cap dividend growers to lock in gains accumulated over the past few years.
A few big-name investors are doing just that, and when a few do it, more are sure to follow. Warren Buffett, for instance, has reduced his stake in large-cap dividend growers Johnson & Johnson (NYSE: JNJ) and ConocoPhillips (NYSE: COP), while selling his entire stake in Intel (NASDAQ: INTC). George Soros and John Paulson have reduced their positions in a number of their large-cap dividend stocks as well.
Admittedly, large-cap stocks offer greater stability. When you compare the beta of a large-cap company to a similar small-cap company, you’ll generally find that the large-cap company has the lower beta (which means it’s historically less volatile).
But smaller cap stocks are better able to grow earnings and dividends when they execute their business plan. Small-cap dividend stocks also have more price-appreciation potential. Obviously starting from a smaller base helps, but small-cap dividend-growth stocks have historically appreciated at a higher rate than their large-cap counterparts.
The chart below produced from Ned Davis Research shows what I mean. Average annual stock returns – price appreciation and dividends – are greatest in small-cap stocks. Large- and mid-cap companies simply can’t keep pace. In short, small-cap stocks get the most bang for their dividend buck.
I’m looking to small-cap stocks to get a bigger bang for my dividend-growth buck, which is why I’m actively vetting the small-cap dividend-growth field. As they say, good things come in small packages. I expect that will be the case for 2014.
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