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When large stocks sneeze small stocks catch colds. But a select group of smaller stocks are resistant to downturns because they are less volatile than their peers and pay dividends along the way.

I used a combined injection of low-volatility and dividends on large stocks to form the Stable Dividend portfolio. This time around I’m using a similar approach to inoculate smaller stocks to form the, imaginatively named, Smaller Stable Dividend portfolio.

The new portfolio starts off with the 400 largest common stocks on the TSX based on market capitalization and then focuses in on the smallest 100 of them.

The largest 300 stocks on the TSX have market capitalizations of more than about $520-million. On the other hand, the next 100 have market capitalizations between about $240-million and $520-million.

In other words, the smaller stocks are pretty small but they’re not tiny. It should be reasonably easy to carefully build a modest position in most of them. But extra caution is always suggested when dealing with smaller firms.

I put the 100 smaller stocks into an equally weighted portfolio and headed off to the back-tester to gauge the returns they offer. The 100-stock portfolio gained an average of 11.1 per cent from the end of 1999 to the end of 2021 when rebalanced annually. The Canadian market, as represented by the S&P/TSX Composite Index, gained an average of 7 per cent annually over the same period. (The returns herein are based on monthly data from Bloomberg and include dividend reinvestment. They do not include fund fees, taxes, inflation, commissions, or other trading frictions.)

Dividend paying stocks often provide a nice return boost in Canada. The smaller stocks were no exception because a portfolio containing only the dividend payers from the smaller 100 stocks provided an average annual return of 13.2 per cent from the end of 1999 to the end of 2021 when equally weighted and rebalanced annually. The portfolio was also less volatile than the 100-stock portfolio.

The Smaller Stable Dividend portfolio takes this one step further. It starts with the 100 smaller stocks, focuses on the dividend payers – and then picks the 20 stocks with the lowest volatilities (over the prior 260 days). Doing so provided another boost to returns, with average annual gains of 13.9 per cent from the end of 1999 to the end of 2021 when the portfolio was equally weighted and rebalanced annually.

The returns improved slightly when the 20-stock portfolio was rebalanced monthly, instead of annually, which resulted in average annual returns of 14.3 per cent from the end of 1999 to the end of November, 2022. The S&P/TSX Composite Index climbed by an average of 6.7 per cent annually over the same period. You can see the healthy returns in the accompanying chart.

The Smaller Stable Dividend portfolio also lived up to its name in that it was roughly 30 per cent less volatile (as measured by its standard deviation) than the equally weighted portfolio of 100 smaller stocks.

But the portfolio’s relative placidity didn’t save it from market downturns. The second chart shows periods when the portfolio, and market index, fell from their prior highs.

The Smaller Stable Dividend portfolio sailed through the collapse of the internet bubble in the early 2000s with hardly a scratch. But that downturn was largely concentrated in high-tech darlings and telecom stocks while many of the smaller stocks that languished in the late 1990s enjoyed a resurgence.

The portfolio managed to dodge the worst of the financial collapse of 2008 when it fell 34 per cent versus the S&P/TSX Composite Index’s decline of 43 per cent, based on monthly data. But it fared a little worse during the sudden COVID-caused crash of 2020 when it fell 30 per cent versus a 25-per-cent decline for the index.

Investing in stocks was not without risk – even after a couple of inoculations. Currently, the Smaller Stable Dividend portfolio sports an average dividend yield of 5.3 per cent and average price-to-earnings ratio of 11.3. Of the 20 stocks in the portfolio, I happen to own small positions in AGF Management Ltd. (AGF.B), Exco Technologies Ltd. (XTC), and Pizza Pizza Royalty Corp. (PZA).

You can find the complete portfolio here, along with updates to the Stable Dividend, Frugal Dividend, and Monster Dividend portfolios.

With a little luck, the Smaller Stable Dividend portfolio will continue to live up to its name and provide healthy returns over the long term.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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