Can Small Caps Pack Big Dividends?

By Miles Lewis - April 5, 2018

High-quality dividends are often associated with large, older, blue chip companies, with market capitalization values of more than $10 billion. Many income investors won't consider companies that are under a certain size or aren't covered in Wall Street research reports. That can spell opportunity for investors searching for yield, as small companies with strong balance sheets and high returns on capital may be a surprising source of sustainable dividends.

Below, we debunk the three most common myths related to small companies and dividends.

Myth #1: Few Small-Cap Companies Pay Dividends

The increase in the number of large-cap companies paying dividends has been well documented. However, a less recognized but equally significant trend is the increase in the number of smaller firms paying dividends. These are firms with market capitalizations between $500 million and $5 billion.

The number of small-cap companies paying dividends has increased dramatically since 2000, and today, almost half of them pay a dividend. Why? The improving quality of management running small companies, as well as the more thoughtful approach they've taken to capital allocation have been major contributors.

This larger universe of dividend payers provides an opportunity for investors to extend their search for yield further down the market capitalization spectrum in the U.S.

Figure 1: Around Half of All Small Companies Pay Dividends

Source: FactSet. 2017 data as of 12/31/2017.

Myth #2: Small-Cap Stocks Do Not Provide Attractive Yields

Figure 2: Yields - Small Caps Vs. Large Caps

Source: FactSet. Data as of 12/31/2017.

Small-cap stocks not only offered attractive rates of return in the past but have also offered a much broader range of higher-yielding stocks relative to large caps. In figure 2 to the left, large-cap and small-cap stocks have had similar dividend yields, but there were many more high dividend-paying small companies from which to choose.

In fact, as of 2017, there were 326 companies with higher dividends than the 10-year U.S. Treasury, a comparison that can be used to gauge the attractiveness of a stock's yield relative to a nearly risk-free alternative.

Myth #3: Smaller Companies are Better off Not Paying Dividends, and Reinvesting in Growth Instead

A commonly held belief is that a smaller company should reinvest free cash flow back into its business to promote growth. Under this premise, paying out free cash flow to shareholders in the form of dividends would represent an opportunity cost to the firm. If that were true, small-cap stocks paying a dividend should underperform their non-dividend-paying counterparts.

In a paper titled "What Difference Do Dividends Make?" (Conover, Jensen & Simpson, 2016), the authors found the opposite to be true. Higher dividend-paying, small-cap value and growth stocks outperformed lower dividend-paying small-cap stocks and did so with less volatility.

Why have small-cap dividend payers outperformed their non-dividend-paying counterparts? We suggest two possible reasons:

  1. If management makes poor decisions on how to use free cash flow, it could cause the business to bleed cash, rather than grow.
  2. Once established, a dividend may become sacred, causing management to make decisions to preserve it. That may also instill a sense of financial discipline that could then lead to a higher-quality, better-performing business model.

In general, small companies may be more susceptible to operational and market weaknesses that result in bankruptcy, as compared to larger, more established firms. Therefore, it pays to be picky, to do the research and to know the health of the small caps you include in your portfolio.

Miles Lewis
Miles Lewis
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      Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.