Meet the new dividend stocks: U.S. small caps

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The case for favouring smaller U.S. stocks is drawing strength from an unlikely source – dividends.

The past year has seen a surge of small-cap companies initiating dividend payments, such that the S&P SmallCap 600 index now has more dividend-paying constituents than non-payers.

"That is unprecedented," said Howard Silverblatt, senior index analyst at S&P Dow Jones Indices LLC. "There are more payers in the small-cap index than there have ever been before."

Not that income investors will abandon large stocks as the primary source of yield from equities. Smaller issues will continue to be mined primarily for growth, but rising dividends add a shot of confidence to the small-cap space, which has resumed its dominance over large caps this year after a 2014 trouncing.

Over the past 15 years or so, small-cap outperformance has been one of the most durable investing themes, with the Russell 2000 small-cap index beating the S&P 500 in all but two years since 1999. The trend persisted even when the bull market was at its strongest, as in 2013; when the large-cap index soared by 30 per cent, small caps posted a 37-per-cent gain.

A couple of broad financial movements are seen as largely responsible for the recent preference for smaller stocks. Prerecession, a multiyear credit expansion favoured small caps, which generally have a tougher time accessing financing. Then, postrecession, battered small caps were well positioned to make back their outsized losses, which is typical of recovery periods.

That all changed last year, when investors rediscovered an appetite for large-cap investing. With the U.S. Federal Reserve having embarked on the long road back to normalized monetary policy, the market embraced the stability and yield of larger stocks. The long stretch of outsized returns in small caps had opened up a valuation disparity against relatively cheap large caps.

"Last year, one of the most popular trades in the world was to go short small caps, long large caps. That trade worked out very nicely up to October," said Jim Furey, chief investment strategist of Furey Research Partners and a consultant to Montreal-based Pembroke Management.

Over that time, the Russell 2000 declined by 9.8 per cent while the S&P 500 ticked up by 1.6 per cent.

In October, however, after a big selloff, U.S. stocks bottomed out and made gains on strength in the U.S. labour market, and the anticipated boost to consumption from falling gasoline prices.

The U.S. dollar also began to make its sharpest gains, and the financial tides shifted once again in favour of small-cap stocks.

Unlike large U.S. multinationals, "small caps don't own huge plants, they don't have enormous contracts, they don't hedge their trade," Mr. Silverblatt said. So a spiking dollar means lower costs on imported inputs for smaller U.S. companies. And since small caps tend to export less, they are the biggest beneficiaries of a resurgent U.S. economy.

Since mid-October, investors have piled back into small caps, with the Russell 2000 registering a 19.7-per-cent gain, nearly double the S&P 500.

That's done little to dispel fears that small caps are overvalued. The aggregate forward price-to-earnings ratio on the Russell 2000 appears stretched at 26.7 times, representing a 53-per-cent premium over the large-cap index as of the end of February, Mr. Furey said.

"However, there are a lot of companies in the small-cap market that lose money," he said. Take out the money losers, and the valuation premium on small caps shrinks to 6 per cent.

In fact, a recent Credit Suisse report said that small caps are currently the cheapest they've been relative to large caps since the end of the tech bubble.

So not only do small caps have room to move on multiple expansion, they are also positioned for earnings growth from U.S. economic improvement and a high dollar.

Those rising prospects have become evident in the number of small-cap companies starting dividend programs, Mr. Silverblatt said.

By the end of the first quarter, the number of S&P SmallCap 600 companies paying a dividend rose by 10.5 per cent from the end of 2013.

"More companies are confident enough in their future that cash flow will be sufficient to cover the initiation of dividends," Mr. Silverblatt said. "When you plan a dividend, you plan on keeping it and increasing it over time."