Dividends Make A Difference For Small-Cap ETFs

Investors typically prize small caps for growth. Rarely are these stocks and standard small-cap exchange-traded funds thought of as dividend destinations — certainly not with the Russell 2000 and the S&P SmallCap 600 sporting an average trailing 12-month dividend yield of 1.46 percent.

There are ways to harness the growth advantage offered by small-caps while tapping into dividend growth as well. That strategy is working this year as dividend stocks are outperforming non-dividend payers, and that is true at the small-cap level, too.

Drafting A Strategy

Just look at the WisdomTree U.S. SmallCap Quality Dividend Growth Fund (WisdomTree Trust DGRS). DGRS, the small-cap sibling of the popular WisdomTree U.S. Quality Dividend Growth Fund (WisdomTree Trust DGRW), is up nearly 5.5 percent year-to-date while the Russell 2000 is up less than 0.9 percent. DGRS is also outpacing the S&P SmallCap 600 by about 140 basis points.

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To be sure, the idea of small-cap growth is enticing, but data suggest small-cap value is by far the better-performing group over the long-term. While the number of small-caps paying dividends has increased in recent years, the number of dividend payers residing in this cap spectrum is significantly less than investors are accustomed to finding in the large-cap universe.

The Potential Of Small-Cap Dividends

DGRS solidifies the notion that investors can have their cake (long-term returns) and eat it too (dividends) with small caps. In fact, data suggest small-cap growth can be a vexing long-term bet.

“Over the last three years, the high-priced small-cap stocks had an average net buyback yield of -5.5 percent, meaning there was a net capital issuance, and therefore a drag of over 5 percent per year that they must overcome to drive future per-share earnings growth. When an investor selects just profitable companies and weights them by their Earnings Streams, the average buyback yield has been slightly positive over this same period,” said WisdomTree Research Director Jeremy Schwartz in a note out earlier this week.

A Different Perspective

Another way of looking at is that many small-cap growth companies, particularly the ones that are not profitable, frequently issue new shares to fuel corporate growth. That dilutes shareholders whereas a profitable company, small-cap or otherwise, can use excess cash to repurchase shares or pay dividends. The 271 stocks held by DGRS are more likely to be in the second category rather than the rampant share issuing group.

Standard small-cap ETFs and their growth equivalents are usually heavily allocated to the healthcare and technology sectors, but those groups combine for just 12.4 percent of DGRS's lineup. A value tilt is apparent with over a quarter of the ETF's holdings hailing from the industrial sector.

“Companies that are constantly issuing shares have to achieve a higher growth rate to overcome the dilution from raising shares outstanding. The companies in our SmallCap Quality Dividend Growth Index are actually reducing their shares outstanding and are priced in such a way that expectations are lower and easier to overcome,” added Schwartz.

Disclosure: Todd Shriber owns shares of DGRW.