Twice As Nice: Small Cap and Dividend Growth

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While the long-term case for dividends - especially dividend growth - as a driver of stock returns firmly appreciated these days, Horan Capital Advisors points out that year to date it’s the non-dividend payers that have outperformed their income counterparts in the index. On a equal weighted basis, non-dividend payers including Google (GOOG), Berkshire Hathaway (BRK-B), Amazon (AMZN) and DirecTV (DTV) had a year to date total return of 24% through August, compared to 17.9% for the dividend payers. Over the past year, the income holdouts are up an average of 30.7% compared to 24% for the dividend payers.

Horan explains that this is being driven by the fact that smaller caps within the index are outperforming, and smaller cap stocks tend not to focus on dividend payouts. Granted, smaller within the context of the S&P 500 is relative, given the smallest, Advanced Micro Devices (AMD) has a market cap of $2.7 billion, and Google at $295 billion is anything but a small cap.

But indeed, while the average market cap for the S&P 500 is more than $62 billion, 64 of the 82 non-dividend payers in the index have a market cap of less than $20 billion, including Netflix (NFLX), Dollar Tree Stores (DLTR) and DaVita Healthcare (DVA). (A quick shortcut to isolate the non-dividend payers in the S&P 500: Use the Screener to zero in on the S&P 500 stocks by choosing “intersect” and then choose S&P 500 under the Index option in the drop down menu. Then move the dividend yield slider to 0%.)

Indeed, bona fide small caps, not just the smaller fry in the S&P 500 have been outperforming lately:

^SLEW Chart

^SLEW data by YCharts

WisdomTree recently launched an ETF that aims to have the best of both worlds: the long-term growth potential that comes from the small cap universe, overlaid with the proven upside of focusing on stocks that are committed to a growing dividend payout. Given the growth mandate for the portfolio, the WisdomTree Small Cap Dividend ETF (DGRS) leans toward more cyclical sectors (consumer cyclical, info tech, industrials) than defensives such as utilities and consumer staples.

Industrials and consumer cyclicals each account for about 25% of fund assets, followed by 13% allocations to technology and the materials sector. The five largest holdings are Questcor Pharmaceuticals (QCOR), Adtran (ADTN), Con-way (CNW), Evercore Partners (EVR) and Meredith Corp. (MDP).

WisdomTree is focused on forward-looking dividend growth potential, not a rear-view screen of past dividend performance. That explains why only Evercore and Meredith have strong back-stories on dividend growth:

QCOR Dividend Chart

QCOR Dividend data by YCharts

WisdomTree starts with its own proprietary index of about nearly 700 small cap stocks and removes the 300 largest from that group. Of the remaining 400 or so stocks, this ETF focuses on the smallest market caps among stocks that currently pay a dividend. A company must have dividend coverage ratio of at least 1. That’s where the dividend criteria ends. From there it’s all about earnings potential and quality—as measured by the three year average Return on Equity and Return on Assets.

Con-way, which traffics in freight transport and shipping logistics, has the highest dividend coverage ratio of the top 5, at more than 4x. But while there’s certainly potential for dividend growth, this is clearly a stock where you have to be firmly focused on ability, not history, as the dividend has held steady for the past five years.

Media company Meredith has a more conventional story. A dividend cover ratio above 1.7 gives room for the company to keep building on growing its dividend; over the past five years the payout has increased more than 80%. Meredith has also recovered from a steep drop-off in ROA, ROE and per-share EBITDA:

MDP Return on Assets Chart

MDP Return on Assets data by YCharts

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.


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