Can Small Companies Pack Big Dividends?


High-quality dividends are often associated with large, mature blue-chip companies. Many income investors don’t consider companies that are under a certain size or aren’t covered in Wall Street research reports. We believe that can spell opportunity for market participants searching for yield, as small companies with strong balance sheets and high returns on capital can be an unexpected potential source of sustainable dividends.

In this paper, we discuss preconceived notions about the availability of yield in the small-cap part of the U.S. market. We focus on debunking three of the most common myths:

  1. Few small-cap companies pay dividends.
  2. Small-cap stocks do not provide attractive yields.
  3. Small-cap companies are better off not paying dividends and instead reinvesting in growth initiatives.

We also highlight research that shows a portfolio of small-cap, dividend-paying stocks historically increased return and reduces risk relative to a portfolio of small-cap non-dividend payers.

Despite these benefits, the universe of small-cap, dividend-paying stocks can be rife with danger if approached naïvely, as evidenced by rampant dividend cuts in 2020.

We believe bottom-up, fundamental analysis is essential to taking advantage of this untapped, but attractive part of the U.S. market.

MYTH #1:

Few small-cap companies pay dividends.

The increase in the number of large-cap companies paying dividends has been well documented in the media. However, a less recognized but equally significant trend is the increase in the number of smaller firms paying dividends.

Figures 1 and 2 show the number of small-cap companies paying dividends has increased dramatically since 2000, and today, around half of the small-cap universe pays a dividend. This increase has been partly driven by the improving quality of management at the helm of small companies and the more thoughtful approach these managers have taken to capital allocation.

Source: FactSet. Data as of 9/30/2020.

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.

Small companies are defined as those with market capitalizations between $500M and $5B.
Source: FactSet. Data as of 9/30/2020.

MYTH #2:

Small-cap stocks do not provide attractive yields.

Small-cap stocks not only offer a broader dividend-paying universe but historically have offered more attractive yields than large caps.

In Figure 3, small-cap stocks have higher average and median dividend yields compared to large-cap stocks.

The example also shows more than double the number of small-cap dividend-paying stocks with yields greater than the 10-year U.S. Treasury versus large caps.

Source: FactSet. Data as of 9/30/2020.

MYTH #3:

Small-cap companies are better off not paying dividends and instead reinvesting in growth initiatives.

A commonly held belief is that a smaller company should reinvest free cash flow back into its business to grow. 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 find 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.

Their research, summarized in Figure 4, shows that return increases, risk decreases and Sharpe ratio increases as the portfolio moves from no dividend payouts to high dividend payouts.

In addition, the authors found that small-cap value dividend payers outperformed their large-cap counterparts on both an absolute and risk-adjusted basis.

For methodology, see: C. Mitchell Conover, CFA, CIPM, Gerald R. Jensen, CFA, and Marc W. Simpson, CFA. “What Difference Do Dividends Make?” Financial Analysts Journal, Volume 72, Number 6, 2016.

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

We Believe Active Management is Especially Important in Times of Crisis

An important investing consideration is whether to use an active or passive manager to build a portfolio of small-cap, dividend-paying stocks.

While no benchmark exists for small-cap dividend-paying stocks, we believe active management is especially important in this asset class given the inherent risk in small-cap investing and potential for dividend cuts.

As Figure 5 shows, small-cap stocks are more likely to cut dividends in times of crisis, illustrated by the number of small-cap companies cutting, suspending or eliminating their dividend in 2020.

Active managers can perform fundamental research to screen for quality, measure dividend safety and conduct stress tests to help mitigate the risk of dividend cuts.

Small companies are defined as those with market capitalizations between $500 million and $5 billion.
Source: FactSet. Data as of 9/30/2020. 

Conclusion

The number of dividend-paying small-cap companies has grown over time and today represents a substantial universe relative to “large-caps.”

We believe small-cap dividend-paying stocks have the potential to provide income equal to or greater than largecap stocks, based on yields as of 9/30/2020.

Empirical evidence indicates that dividend-paying smallcap stocks have historically provided higher returns with less volatility than non-dividend payers.

We believe active management is crucial to help mitigate the risk of dividend cuts, eliminations and suspensions.

Market Perspective - Can Small Companies Pack Big Dividends?

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.

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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.

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