Big, blue chip stocks are often the first stop for many dividend investors. Companies like Exxon Mobil or Procter & Gamble have long histories of paying dividends and higher yields than the market’s average. But smaller companies pay dividends too, and some mutual-fund managers count them among the best opportunities to find dividend growth.
That’s why Don Taylor, who has managed the Franklin Rising Dividends fund since 1996, prefers companies a tier or two below the dividend behemoths. He considers the sweet spot to be companies valued between $20 billion and $50 billion. Exxon Mobil, in comparison, is worth $422 billion, and Procter & Gamble, more than $219 billion. The average market value of companies in the Standard & Poor’s 500 index is $36 billion.
One of the biggest investments in Taylor’s fund is Roper Industries, an industrial company worth $14 billion. At first glance, it may not look like a great dividend stock with a yield of 0.6 percent. Taylor has been comfortable with the low yield because Roper has been using a lot of its cash to buy competitors to accelerate its growth. Those acquisitions helped Roper’s annual revenue nearly quintuple over a decade and top $3 billion last year.
But finding acquisitions big enough to make a significant impact on its results – at attractive prices – is getting tougher. So Taylor expects Roper to steer more of its cash toward its dividend. Earlier this year, Roper hiked its payout by 21 percent.
Some dividend-focused mutual funds focus on even smaller companies. The Principal Small-MidCap Dividend Income fund concentrates on stocks with market values below $7 billion, for example. It has a four-star rating from Morningstar.
“People tend to overlook these small and mid-cap companies,” says Jill Cuniff, president of Edge Asset Management, which runs the fund. “This space is absolutely under-covered by Wall Street,” enabling investors to find underappreciated dividend payers.
The fund has been focusing on Business Development Companies, or BDCs, for example, which invest in small and mid-size companies.
Cuniff expects these companies, which are generally small in size, to grow due to heightened regulations at competing big banks.
BDCs are also structured in a way that allows them to pass on most of their earnings to investors without paying corporate income taxes. That means they can offer dividend yields as high as 9 percent, though their stock prices have also been volatile in recent months.
To be sure, smaller dividend stocks aren’t sure things. A big run up in prices for the smallest stocks during this bull market means they generally look more expensive than large-cap stocks relative to their earnings. Small-cap stocks can also have sharper declines than bigger companies when markets are rocky.
But adherents say that dividend payers among small-cap stocks aren’t as expensive as their high-growth peers. They also point to the pluses of dividend stocks in general:
• Returns when stock prices are volatile: The value of dividends shone through in 2011. That year, the S&P 500 index was virtually flat after worries about the European debt crisis and a downgrade of the U.S. credit rating shook markets. But the index nevertheless returned 2.1 percent after including dividends.
From 2000 through 2010, the S&P 500 dropped 14.4 percent, but the payment of dividends meant that it still had a positive 4.6 percent return.
• Income in a low-yield world: With populations aging around the world, the appetite is high for income-producing investments. Bond yields remain low, and many income investors have moved to stocks in search of greater returns.
Edge’s Cuniff says some of the strongest demand she’s seeing for its dividend-focused strategies is coming from Asia and elsewhere outside the United States.
• A commitment to investors: Some investors find reassurance in seeing actual cash payments from companies, particularly after the lingering effects of Enron and other accounting scandals. When a company pays a dividend, it also forces a level of discipline on its managers. CEOs are reluctant to cut a dividend for fear of a backlash by investors.