Does a Dividend Portfolio Need Small-Cap Stocks?

Written by The Dividend Guy on October 9, 2007

As a dividend investor, especially a dividend investor honed in on companies that consistently increase their dividend payments, my focus tends to be on the larger scale companies - the big blue chip stocks that consistently increase their dividends. One area I have not spent much time on is looking at small-cap stocks and how they might fit into my portfolio. I have done some research and have concluded that I should have some small-cap stock exposure - here is the results of that research.

What are small-cap stocks

There are a lot of definitions for what a small-cap stock is, and they all seem to differ. The best one I found, and the one that I am going to go with, is the definition that Morningstar has for the various market capitalizations of stocks:

Large Companies: comprising the top 70 percent of U.S. market value
Medium Companies: comprising the top 20 percent of U.S. market value
Small Companies: comprising the top 10% of U.S. market value

Notice that it is not a definitive number, like anything below $5 billion is a small-cap. Instead, are viewing it from a relativity perspective in comparison to the entire market. Market caps can vary for companies from day-to-day so this approach makes more sense. Based on the data in Jason Kelly’s book, The Neatest Little Guide to Stock Market Investing, in 2002 large companies were about $10 billion and up, medium companies at about $2 billion, and small companies at less than $2 billion.

Why do small-caps matter

In a nutshell, small-caps post better returns over the long run than large-caps do. As pointed out by Sun over at The Sun’s Financial Diary, the return from small-cap investments is 2% higher than the return from large-cap stocks from a historical perspective. 2% over a 25 year investing period is a lot of money. This table from Vanguard presents this evidence:

Small-Cap Performance

Keep in mind that the article goes on to discuss that there are periods of time that small-caps do not outperform large caps when viewed from different periods of time. In addition, it talks about the added risk an investor takes when incorporating small-caps. The standard deviations can be much more dramatic which makes holding periods very important. If you are an investor who has a weak stomach for market drops or in not in it for the long term, then small-caps are not for you.

Just to further satisfy my belief that small-caps have performed better than large-caps, I looked at the Russell website to obtain historical data on the Russell 2000, which is an index that tracks the small-cap component of their broad market index. The data is clear that small-caps have performed better than large-caps:

Russell 2000

Does a Dividend Portfolio Require Small-Caps?

There is a theory that exists in investing research that it is not individual stocks that impact a portfolio’s return the most - it is two other factors. To explain this, I went to Ken Fisher’s book, The Only Three Questions that Count. In it he explains the portfolio construction process as a funnel that looks like this:

Ken Fisher’s Portfolio Funnel

The important thing to note here is that it is asset allocation that influences a portfolio’s return the most - to the tune of 90% combined. Security selection has a much lower impact. The second most important factor is the sub-asset allocation such as market cap.

Why is this important - because if our future returns are not going to be influenced entirely by our stock selections, we need to spend some time on the other influencers that will impact us. I have spoken about global diversification and its importance. Small-cap representation is similar in that we are trying to balance our risk and reward - small-caps open us up to more risk but for potentially higher returns than just investing in domestic large-cap dividend paying stocks. I am comfortable with the added risk as I have at least 20 years until I will draw from my portfolio.

Conclusion

Based on all this data, I beleive that small-cap stocks do have a place in a dividend investment portfolio, especially at the accumulation stage (i.e. a long investment horizon). I base this decision on the above mentioned factors:

1. Small-cap stocks have provided better returns for investors than large-cap stocks
2. If asset allocation and sub-asset allocation decisions influence 90% of a portfolio’s return, then consideration to those other sub-asset classes needs to be incorporated.

I would like to hear your thoughts on this - please use the comments below to voice your opinion so we all can learn from others experiences with small-caps and how they fit in to your portfolios.

In a follow-up post, I am going to present how I am going to invest in small-caps as part of my investment portfolio, including how much of my I will allocate to small-caps and what securities to invest in.


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16 Comments so far

  1. george harris October 9, 2007 7:06 pm

    I agree with your analysis and I’ve seen favorable comparisons of small cap value returns in other articles. I’m particularly interested if your small caps selections also turn up the double whammy of some paying dividends, or beter yet increasing dividends.

    Moneychip.com had the following chart; compounded over 78 years, $100 would translate to;

    Value Growth
    Large Cap $898,697 $130,165
    Small Cap $7,307,903 $103,626

  2. george harris October 9, 2007 7:12 pm

    Sorry,Let me try chart again…

    ———————-Value—————Growth
    Large Cap………$898,697…………..$130,165
    Small Cap…….$7,307,903…………..$103,6262

    The point being, small cap value particularly if paying dividends could be great additions.

  3. Around the PF Blogosphere: October 9, 2007 | The Sun’s Financial Diary | A Personal Finance Blog on Saving and Investing October 9, 2007 9:26 pm

    […] Dividend Guy discussed whether small-cap stocks should be part of a dividend portfolio. Small-cap has a place in a diversified portfolio, whether it’s dividend oriented or […]

  4. Troy R October 10, 2007 8:14 am

    Hold everything… you can have both high dividends AND small cap! Check out the small-cap high yield ETF from wisdomtree (ticker DES). Reviewing the stock stats and index selection process I really don’t see much that not to like. The only issue I see is high financials exposure and low volume. Comments?

    Troy

  5. Troy R October 10, 2007 8:16 am

    Wisdomtree’s Small Cap ETF (DES) currently has a gross dividend yield of 4.13% and an expense ratio of .38%. Not bad…

    Troy

  6. Mats October 10, 2007 5:58 pm

    Aren´t you making a generalization out of the recent years?

    It is true that small company stocks have gone really well the last few years. But in the last few years of the nineties, it was the Big Blue Chips that went well. The argument was, in those years, that the large companies would always be more profitable.

    Instead of concluding that whatever has been popular among investors in the last few years will continue to be popular, you could argue that anomalies do occur and investors walk in herds.

    Diversification is in either case a very good strategy.

  7. The Dividend Guy October 10, 2007 10:08 pm

    Mats - that is a good point and something I have also read about - however the data does go back to 1927 showing that small-caps (especially value ones) have outperformed large caps. There is always going to be times when small-caps don’t out perform - it is the diversification that matters as you said.

    Thanks for visiting.

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  15. Larry Minton November 16, 2007 1:38 am

    I found Paul Merriman’s advice on asset allocation at http://fundadvice.com to be very interesting and I am using it with Vanguard index funds along with Wisdom Tree ETF’s and large cap dividend paying U.S. large value stocks.
    I am happy to have come across your post tonight and have subscribed to the feed.

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