Investors dream big when looking for dividends. They love large stocks with generous yields. But big isn’t always better because small dividend payers have plenty to offer.
To highlight the advantages of thinking small, it’s useful to look at past returns. A fortunate investor would have gained an average of 12.8 per cent annually by buying an equal amount of all-Canadian dividend stocks on the TSX with market capitalizations between $200-million and $2-billion over the 16 years through to the end of 2017.
By way of comparison, a portfolio with an equal amount of the relatively large dividend paying stocks in the S&P/TSX Composite Index gained 10.2 per cent annually over the same 16 years. The index itself, which is a good proxy for the Canadian stock market, averaged an annual return of 7.5 per cent over the same period.
(All of the returns herein include dividend reinvestment and do not include fund fees, taxes or other trading frictions. The dividend portfolios are rebalanced at the end of each year.)
The gains for the small stocks were stellar, but the ride was painful at times. When the market crashed in 2008 the S&P/TSX Composite fell 33 per cent for the year. The portfolio of large dividend stocks cushioned investors with a slightly less painful 29-per-cent drop. The small dividend stocks suffered more with a decline of 35.1 per cent. While the small stocks generated big long-term returns, they came with harsh short-term drawdowns, which some investors would find hard to stomach.
I investigated the small dividend payers in more detail by putting them through the Bloomberg back-tester. The small stocks, with a market capitalization between $200-million and $2-billion, were sorted by indicated dividend yield at the end of each year and put into five portfolios (called quintiles) containing an equal number of stocks. (The stocks were split into five groups rather than 10 because there were relatively few candidates to pick from in the early years.)
The portfolios were tracked and the results shown in the accompanying chart, which highlights the annual performance advantage offered by each group against the market index over the 16 years to the end of 2017.
For instance, the middle portfolio of medium-yielding stocks grew at a compound annual rate of 14.1 per cent and outperformed the S&P/TSX Composite Index by an average of 6.6 percentage points per year. Over the 16 years, an investment in it would have turned $100,000 into about $825,000, while an investment in the index would have grown the same amount to about $319,000.
The portfolios with the most extreme yields still beat the market but fared poorly compared with those that have more moderate yields. The small stocks with the highest yields had the worst relative showing.
Because I’m leery of stocks with extremely high dividend yields, I split the highest yield portfolio in half by yield. That is, I tracked one portfolio of stocks with the highest 10 per cent of yields (the top decile) and another portfolio that contained the next highest 10 per cent of yielding stocks. (Both contained just a handful of stocks in the early years.)
The small stocks with extremely high yields (the top decile) gained an average of 7.4 per cent annually over the 16 years and lagged the market index slightly. The second-highest decile fared better with average annual returns of 13.5 per cent. Incidentally, the poor performance associated with giant dividend yields isn’t limited to small stocks; in a previous column I found this applies to large dividend stocks as well.
Small dividend stocks deserve a spot in a well-diversified portfolio owing to their return potential. But treat them with caution and due consideration. Investors should be particularly careful when dealing with firms with extremely high yields.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.