It's easy to feel good these days as stocks keep hitting new highs. But seasoned advisers know there's plenty of uncertainty out there ? a tumultuous political environment, the Federal Reserve revving up its tightening cycle, federal spending and tax plans constantly evolving, geopolitical turmoil, etc. ? that could wreak havoc on even the best-constructed portfolios. We believe there's an asset class that can potentially help keep diversified portfolios resilient in the face of uncertainty: small- and mid-cap dividend-paying stocks.
Setting the record straight
The case for small- and mid-cap dividend-payers starts with the case for dividend investing generally, which suffers from three common misconceptions. We'd like to dispel these misconceptions and set the record straight.
1. Too expensive. Many investors believe that the quest for higher yields has made dividend-payers more expensive than non-dividend-payers. This simply isn't true: Recent work by Ned Davis Research concludes that among small- and mid-cap stocks, dividend-payers have lower forward and trailing price/earnings ratios than non-dividend-payers.
2. Underperformance when rates rise. While the idea that yield-based assets would underperform in times of rising interest rates or inflation makes sense, it doesn't apply to dividend-payers. This is especially important to keep in mind as the Fed remains on course for multiple rate hikes going forward.
Historically, small-cap dividend-payers have outperformed not only in most periods leading up to the first hike in a tightening cycle, but also in the one-, two- and three-year periods after the cycle begins. As for mid-cap dividend-payers, they generally underperformed in the year before and after the first tightening, but significantly outperformed in the second and third post-tightening years. We find more opportunities in the lower-yielding area of the markets – especially in the small- and mid-cap universe – in part because this area of the market typically displays far less interest-rate sensitivity than their high-yielding brethren.
3. Use ETFs instead. It's tempting to take a passive approach for exposure to dividend-paying names, since ETFs often can be an effective industry surrogate. But we see this as the wrong way to go.
The problem here is sector allocation. Many ETFs have significant exposure to the more traditional dividend-paying sectors like REITs and utilities ? which leaves them underexposed to sectors with strong secular growth trends such as tech and health care. There are many exciting dividend-paying companies in these sectors that offer attractive upside potential.
In our view, advisers should consider getting more creative in their portfolio construction techniques by taking a more active and sophisticated approach to dividend exposure, where risk can be better controlled at the sector level while gaining exposure to dividend-payers.
Overlooked and underrated
While large-caps tend to be the most recognizable names among dividend-payers, small- and mid-caps have an impressive long-term track record that has flown under the radar.
Ned Davis Research has calculated a number of key metrics over the 1983–2016 period for dividend-paying small- and mid-caps, and compared them with their non-dividend-paying counterparts. The results are eye-opening. For example:
• Small-cap dividend-payers generated an average annualized return of 13.3% versus 7.8% for non-dividend-payers. The comparable returns for mid-caps were 13.3% and 10.4%, respectively.
• Small-cap dividend-payers handily outperformed in both up and down markets. Mid-cap dividend-payers did so in down markets and kept up in up markets.
• As measured by standard deviations, volatility was significantly lower both for small- and mid-cap dividend-payers.
• Correlations for both small- and mid-cap dividend-payers with their respective core, growth and value benchmarks are sub-1.00 – as low as 0.70 relative to the Russell 1000® Growth Index.
For a deeper dive into the numbers and analysis, please see our recent white paper, Deconstructing Dividends: A Closer Look at the Virtues of Dividend-Paying Stocks.
A place in any portfolio
It's clear that dividend-paying stocks should have a place in any well-diversified portfolio built to last. They offer a compelling combination of yield and — unlike bonds — no ceiling on potential gains in price as well as income. Their favorable risk/return profile and diversification benefits are attractive for income- and growth-oriented clients alike.
Investing in small- and mid-cap dividend stocks isn't a magic bullet, of course. Just as with all investing styles and approaches, there are risks. For example, investing in small- and mid-cap stocks may be more volatile – and loss of principal could be greater – than investing in large-cap stocks. While a company's track record of paying dividends provides useful historical perspective, a company's dividends are not guaranteed. Dividends may be limited, and a company's dividend-paying ability could cease in times of market downturns or unfavorable economic conditions. And while we believe small- and mid-cap dividend-payers are great diversifiers, diversification does not eliminate the risk of investment loss in a client portfolio. We especially recommend an allocation to small- and mid-cap dividend-payers, whose outstanding record over the long haul merits serious consideration as a core portfolio holding.
Derek Anguilm and Lisa Ramirez are portfolio managers on the Value team at Denver Investments, manager of the Westcore Funds. The Westcore Value Equity funds invest in dividend-paying companies whose stocks appear to be undervalued.