When The Investor asked me to continue my series on dividend investing, I decided it was time to step out from behind my moniker. The name’s Todd Wenning, aka The Analyst, nice to meet you. Please see the bottom of this post for full details. As a regular Monevator reader who enjoys the community here, it’s a pleasure to be back with you talking dividends!

Today I’d like to explore dividend-paying smaller companies, also known as small cap shares.

Look through most dividend-focused portfolios, and you’ll find them heavily weighted toward blue-chip stocks. There’s nothing wrong with that, and FTSE 100 companies can serve as a solid anchor in a dividend portfolio.

That said, large companies tend to be the most covered companies by the City, and there are thus limited opportunities to outfox other investors.

Small cap dividend shares, on the other hand, often fly under the City’s and other investors’ dividend screens. I believe this makes them attractive candidates for those of us doing our own fundamental research.

Further, even if large investors wanted to invest in small caps, they frequently run into the problem of not being able to buy enough of the business to make a difference in their portfolios.

As individual investors, we can take more significant stakes in small companies.

Not for everyone

Naturally, small caps aren’t without their risks.

Relative to large caps, small caps tend to be less diversified, have a harder time accessing capital in recessions, and their executives may jump ship when offered a bigger paycheck at a larger company.

Not to mention their share prices are usually much more volatile. Daily moves of 5% or more in either direction are not uncommon.

As such, wading into the small cap pool requires patience, a business focus, and a stoic mentality.

So when evaluating small-cap dividend-paying stocks, I get interested when I see one or more of the following attributes.

1. Low debt or preferably no debt

A few years ago I was speaking with the tenured CFO of a small cap firm in the U.S. His company had a net cash balance sheet (i.e. they had more cash than debt) and I asked him if he was under pressure to increase the company’s borrowings.

He replied that whilst investors were urging him to borrow now (in a good market), those voices were silenced during the financial crisis a few years earlier.

Debt’s siren song can be enticing for small enterprises wanting to get big quickly. Too often they forget that leverage cuts both ways. If the economy, industry, or company faces a downturn, that extra leverage only exacerbates the problem and puts the company at risk.

As Warren Buffett put it in his 1987 letter to Berkshire Hathaway shareholders: “Really good businesses usually don’t need to borrow.”

All else equal, it’s a positive sign when a company can grow using internally generated cash.

2. An invested leadership team

If I’m going to invest in a smaller company, I want to see that my interests and management’s are aligned to the greatest extent possible.

One way to check this is to evaluate management’s incentives.

When reading the remuneration report, ask yourself, “Upon which metrics are management’s bonuses based?” and “Will those metrics encourage the right behaviour?”

I also like to see that management and the board together own at least 5% of the outstanding shares. By having skin in the game, they are less likely to take undue risks or pursue growth-at-any-cost acquisitions that might jeopardize the dividend.

3. Steady free cash flow generation

Since dividends are paid from free cash flow (i.e. the money left over after the company reinvested in the business), it’s a positive sign when the company has displayed an ability to generate free cash in various markets.

A pure commodity company, for instance, may have bumper free cash flow during booms, only to burn through cash in the troughs

Volatile cash flows are a less-than-ideal scenario for dividend investors. Instead, focus your attention on firms that can deliver cash flow in both good and bad markets.

Steady free cash flow generation across the business cycle can also serve to build the board’s confidence in the business’s long-term prospects, leading to dividend increases every year.

4. Dominant in a profitable – ideally boring – market niche

What’s the firm’s Total Addressable Market (TAM)?

If the company is growing rapidly in a large TAM (say, social media) it will surely attract competition from larger firms with robust resources.

On the other hand, a large company will likely either acquire a small company that’s dominating an attractive-but-limited TAM, or else leave it alone.

If the small company operates in a decidedly dull industry – think industrial parts, safety equipment, waste management – then that’s even better. These industries are less likely to attract new participants. This helps the small company maintain profit margins and free cash flow production to support the dividend.

5. A payout ratio below 50%

Companies, large or small, that pay out much more than 50% of their free cash flow are likely in mature or declining industries. These types of companies can boast high yields make for good investments at the right price, but if dividend growth is important to you, focus instead on companies with ample cash flow after dividends.

If you trust the management team and there are good reinvestment opportunities, management can plow the extra cash back into the business to accelerate growth.

Conclusion

Given the relative lack of City coverage, investing in small-cap dividend-paying shares takes some extra research on your part. Yet because they aren’t often included in popular dividend-themed ETFs or mutual funds, I believe the return on your research time can be higher than if you focused solely on blue chips.

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.

Most people who invest their money for the long-term decide they should own some shares (or equities, as they’re also called).

This is a good idea. Over the past 116 years, the UK stock market has historically delivered an average after-inflation return of 5.5% a year.1

In comparison, bonds have returned on average just 1.8% after-inflation over the same period, and cash a puny 1% a year.

So shares look like a winner when it comes to money you plan to tuck away for long-term growth, such as in a pension.

But what is a share?

What a share is

Shares denote slivers of ownership of companies.

By owning a slice of a company via its shares, you’re entitled to a portion of the wealth that the company generates over time.

Your particular entitlement varies with the size of your stake – in other words, the number of shares in the company that you own.

Western economies have tended to expand over the decades (boosted by inflation).

This economic growth has been reflected in the performance of our publicly owned companies, which in aggregate have become much more valuable over time.

As a result, shares have provided the best gains for investors over the long-term compared to the fixed returns from assets such as cash and bonds.

Share prices can go up and down

To be clear, the shares we’re talking about here – shares in public companies – are those traded on the stock markets.

Such trading means that as well as often receiving an income from your shares – called a dividend – you can also sell your shares in the future. Hopefully at a higher price than you bought them for!

This combination of dividends and capital growth is how shares deliver their returns to investors.

However it’s important to realize that the value of shares does fluctuate both ways – that is, their prices go down as well as up.2

In a stock market crash in particular, share prices can fall a lot.

Hitherto most Western markets have eventually bounced back, even from big slumps like we saw in 2008. This has rewarded investors who sat through the crashes rather than selling.

Nevertheless, until prices do recover your wealth has been reduced – even if you prefer to think of it as a paper loss because you haven’t sold.

Such volatility (and uncertainty) is what makes shares riskier investments than cash or bonds.

You simply don’t know what your shares will be worth on any given day or month, even if you believe that over the long-term you’ll be rewarded for owning them.

And when prices do fall, it can take years for them to recover.

Look at this graph showing how the UK stock market has behaved since the year 2000:

As you can see, since 2000 investors in the UK market have had to endure two big declines. There was a slow slide from 2000 to 2003, and a sharper slump around the financial crisis, beginning in 2007.

Indeed, if this graph were the only evidence you were ever shown about investing in shares, you might wonder why you’d bother.

The level of the market today (right hand side of the graph) is not hugely higher than where it was in 2000 (left hand side), even after enduring all those ups and downs.

Some reward!

It’s important to note though that this graph, like most stock market graphs you’ll see, only shows capital growth. It doesn’t include the dividend income I mentioned.

Dividends are worth about 3-4% a year from the UK market. The total return picture is much more attractive if you assume dividends paid were reinvested back into the market every year.

We saw that in the historical return figures I quoted at the start of the article, which do include dividends.

Also, even 17 years is only really just getting into the ‘long-term’ when it comes to shares.

For a wider perspective on how shares can deliver strong gains over time, here’s a graph of how the US market has performed since the late 1970s:

Since 1977, the US stock market is up more than twenty-fold. Again this does not include dividends, which would have massively boosted those capital returns if reinvested.3

I know that 1977 may seem a very long time ago, particularly if you’re young.

But if you’re in your mid-20s, say, then you’ll probably be saving for your retirement for 40-odd years. Forty years would take you back to 1977, where many people like you began investing in US shares for their own retirement.

Certainly there would – in retrospect – have been better and worse times to invest over those long four decades.

But the main thing to notice is the pattern of slumps and recoveries. This is what you have to steel yourself for when you invest in shares.

Don’t lose it entirely

It’s also important to note we’ve been looking at overall stock market movements so far.

Put simply, when we say ‘markets’ in this context, we’re referring to the shares of all the companies listed and traded in a particular country.

So the UK market refers to the shares of companies listed on the London Stock Exchange.

Data providers further divvy these shares up into various stock market indices. These indices makes it easier to track the performance of groups of companies, among other things.

For instance, in the UK we have the FTSE 100, which is the index of our 100 largest listed companies.

We also have indices that track the shares of energy and mining companies, indices of smaller companies, property companies, and so on.

Now, when I say markets have always bounced back from the worst crashes, that’s true in all but a handful of cases.4

But individual companies, in contrast, can and do go bust. And when a company goes bust, its shares can become worthless.

If you’re an investor in a company that goes bust – or one that simply goes down a lot in value and you sell, for that matter – then you will lose money.

There’s no compensation schemes or other protections in that case.

When you buy shares you are a true investor in a business venture. And when the business goes bust, the venture did not turn out well.

Diversify your shares

We see a picture then where stock markets overall have tended to post great long-term returns, even though some of the companies trading on those markets have delivered diabolical results.

In the worst cases big companies have gone bust, and their shares have become worthless.

What is happening here?

The seeming contradiction is simply down to the strong returns from the very best performing shares more than making up for the terrible returns of the worst.

• The most value that can be destroyed when a company goes bust is 100%.

• But if a business does very well or becomes very popular with investors (not always the same thing) it can go up in value by 200%, 300%, 10,000% or more.

This wide variation of returns from individual shares – together with the risk of permanently losing your capital in any that fail – is why it’s super important to diversify your holdings across many different companies.

Fortunately this is nowadays easily done.

The easiest way to invest in shares

As we’ve seen, deciding you should own some shares only opens another can of worms!

Besides preparing yourself for the market’s ups and downs, you might also consider:

• What amount of shares is it best to own for your age, income, aims, and attitudes towards risk?

• How do you decide which shares to own?

• What’s the best way to own them?

We can’t answer the first big question in this short piece, but other Monevator articles can help you create your own plan.

However for the other two questions, we’re convinced the simplest way for most people to own shares is via a global equity tracker fund.

Such a fund holds small stakes in many thousands of companies all over the world. This hugely diversifies your investments – not only across different shares, but also across different countries, currencies, and business types.

And as a tracker fund, it’s a low-cost passive investment that will leave more of your money free to compound over time.

• Before you invest you should read more about the benefits of a global equity tracker fund.

• We’ve also written about how to choose the right global tracker fund.

For much more on passive investing in general, head over to our passive HQ.

Key takeaways

• Shares are slices of ownership in publicly traded companies.

• Over the long-term, the returns from shares have outpaced those from bonds and cash.

• Share prices can go up and down, and in the worst case you can lose all your money.

• Overall though, stock markets have tended to go up over time.

• Diversifying your money across the shares of many different companies helps protect your investment from the worse outcomes.

• A global tracker fund is a cheap and effective way to invest into a diversified portfolio of global shares.

This article about shares is one of an occasional series on investing for beginners. Please subscribe to get our articles emailed to you and you’ll never miss a lesson. Why not tell a friend to help them get started?

1. My data here on returns for UK shares, bonds, and cash all comes from the Credit Suisse Yearbook 2017. [↩]
2. To a lesser extent the dividends they pay are volatile, too. Dividends can be reduced or even cancelled by a company if it hits hard times. [↩]
3. Unfortunately most graphs of stock market returns don’t incorporate the impact of reinvested dividends. [↩]
4. The most important exceptions are Russia, China, and Germany, where markets were disrupted by revolution and war, and Japan, which is still well below the peak it reached in the late 1980s. [↩]

Good reads from around the Web.

I believe humans are causing climate change. There is overwhelming consensus among scientists. Those who argue otherwise almost invariably come from a certain demographic, who I won’t name because I told reader @mathmo I’d try to be more sparing with labels.

Suffice to say, they might as well argue against gravity.

If Einstein wants to argue with scientists1 about gravity, I’m interested. If a middle-aged Top Gear fan wants to argue with scientists about climate change, they can do so elsewhere.

Liberal Snowflake credentials safely re-affirmed then, let me get to my own indignant outrage.

Why is the government’s workplace pension provider Nest making active investment decisions based on its employees’ opinions about climate change?

Nest knows best

In a short interview last week, Nest’s director of investment development explained to Share Radio that it had identified climate change as a key risk to returns.

According to The Guardian, the pension provider is therefore shifting around 10% of its members’ investments into a new climate change fund that dials back on fossil fuel firms and favours renewable energy:

Nest is now looking after the pension pots of more than four million UK workers, investing £1.5bn on their behalf, and has signed up more than 290,000 employers.

These numbers are expected to increase markedly over the next few years, making Nest a major shareholder and, it hopes, a difficult voice to ignore.

Why is Nest making such decisions for its members? Why does it need a voice? Why is it not just investing in tracker funds?

As we all know around here, most active funds fail to beat the market. Why is the default option for auto-enrolled workers not just a cheap and effective global index fund, paired with a bunch of gilts?

Climate change is hardly a hidden risk. Even Exxon Mobil’s new chief executive recently reiterated the company’s call for a carbon tax to help address it.

The market price of Exxon, Shell, BP, and other fossil fuel firms will normally reflect these known risks – as well as the potential rewards of owning vast reserves of a super-potent fuel.

What do Nest’s decision makers know that the market does not? Nothing, I would suggest. As far as I am aware they are not drawn from the sliver of proven billionaires who’ve made their fortunes reading the market’s runes.

They are no doubt perfectly decent salaried employees, doing what they think is right. But I think they’re getting it very wrong in the process.

I agree environmental degradation is a huge threat. But the market will determine over the next couple of decades whether the reserves of big oil companies and the like will end up ‘stranded’ and left in the ground, and if so which alternative energy will take up the slack.

My own hunch is solar, but I wouldn’t bet four million citizens’ retirements on it.

Whose retirement is it, anyway?

Incidentally, we get a lot of emails from people who want to invest passively but don’t want to invest in, say, big oil companies, or banks, or bomb makers.

We’re overdue an article on this. I understand the thinking, even if I’d suggest your views are perhaps better expressed outside of your portfolio. But the point is it’s your personal decision.

I can’t find recent figures, but as of 2013 the stats showed that 99% of Nest savers were in the default fund. These people are not making an active choice to bet against the market on fossil fuels. I doubt most realise their pension provider is, either.

Pension auto-enrollment is a great initiative, but making these active decisions risks undermining the whole project. Tracker funds exist and they do the job best for the greatest number of people. It’s maths.

I think the government should go to Vanguard, Blackrock, and the other leading tracker providers and play them off against each other to get a special deal for bringing four million new customers to the table. Then get out of the way.

[continue reading…]

1. i.e. Propose a new working hypothesis. [↩]