Reap Big Rewards with Small-Cap Dividend Stocks

Small-cap investing represents the notion that you can buy a stock at the ground level before it becomes a blue chip, mainstay stock. Blue chip dividend stocks, on the other hand, give investors their fair cut of an established company’s earnings and growth.small-cap-dividend-stocks
You’d be hard pressed to find many investors that ever discuss the two ideas together. But small-cap dividend stocks have the potential to provide the best of both investment strategies.
There’s no universal definition for small-cap stocks, but they are typically companies with a market capitalization between $300 million and $2 billion. Small caps are more likely to give shareholders a better chance at big, short-term gains. A $50 million contract for a small software maker has a much bigger impact on that business than one that goes to Microsoft (NASDAQ: MSFT).
So you shouldn’t be surprised if I tell you that according to Morningstar Research, small caps have outperformed blue chips by a margin of 2.4% annually since 1926.
A company with a steady dividend has already proven that it hit the most important milestone in the business world: it makes more than it spends year in and year out. Any enterprise shoots for that basic goal. But not all achieve it.
Researchers from Dreyfus Funds found that over a 40-year period ending in 2013, stocks that paid a dividend averaged an annual return of 9.3%. Those that didn’t pay a dividend averaged just 2.3%.
So both approaches work. Small caps outperform large caps. And dividend payers outperform non-dividend payers. But because small-cap investing sounds too speculative to the conservative dividend investor types, and dividend investing sounds too slow and boring to the small-cap investor types, that’s where the conversation usually ends.
But let’s take a look at what you actually get if you stick this idea out and combine both equity classes. Since dividend stocks – especially those with larger than average yields – are essentially deep-value stocks, let’s compare how small-cap value stocks have fared against those high-flying small-cap growth stocks every speculator loves going after.
From 1972 to 2013, small-cap value stocks outperformed small-cap growth stocks 13.9% to 9% annually. That’s almost a 5% difference. When your broker tells you that it’s not a bad thing that your account fell 2% last year, consider how making 5% sounds instead.
The problem for investors seeking to combine these two investment styles is that they often don’t know where to look to invest in small-cap companies that pay reliable dividends. Fortunately, in the modern investment landscape full of exchange-traded funds, there are now a few easy ways to go about it.
WisdomTree SmallCap Dividend ETF (NYSEArca: DES) is the most well-respected and oldest small-cap dividend ETF around. With assets totaling more than $1 billion, it should be a mainstay for any portfolio that seeks to capture a cut of that extra 5% in annual returns.
The DES fund has a low expense ratio of just 0.38% and great diversification, with no single holding representing more than 1.5% of its portfolio. But the most important argument for owning DES is its performance. Since the market crash in 2008-2009, DES has handed investors a return of 372% compared to the S&P 500’s 211%.
WisdomTree US SmallCap Dividend Growth Fund (NASDAQ: DGRS) is basically DES’s little brother. But it packs more of a hit. The DGRS fund’s 15 largest stock holdings represent 22% of its portfolio, versus just 12% for DES’ top 15 stocks.
DES will give you a fair representation of how all small-cap dividend stocks perform each given year. DGRS cherry picks only stocks that are growing their payments. And that means it has only the best small-cap dividend stocks in its portfolio.
Hercules Technology Growth Capital Inc. (NYSE: HTGC) is the oddball here. It’s not an ETF, but it is fund-like.
Hercules is considered a business development company. Simply put, it invests in the smallest of businesses right after their startup phase. These are companies that have already proven they can sustain earnings and growth. Hercules simply helps them expand their businesses, for a sizable cut of earnings.
The best part of investing in Hercules is that it pays out 9.1% in dividends each year. That’s the ideal small-cap dividend player: a company that invests in the smallest, yet safest businesses – and pays a remarkable dividend itself.
The real play here is to consider investing a portion of your money in each of these three securities. With DES, you’ll capture that extra 5% and have a well-diversified investment. With DGRS, you’ll have a large cut of the very best of the small-cap dividend stock universe. And with Hercules, you’ll get paid extravagantly to safely invest in even smaller, non-public businesses.

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