The Ugly Truth of Growth Investing in 2016
It’s easy to get excited about small-cap growth stocks. Uncovering the next Apple (AAPL), Microsoft (MSFT) or Tesla (TSLA) is an undeniably alluring prospect. And it’s what I devote most of my days to. But there’s another facet of small-cap investing that’s far less glamorous, but also incredibly lucrative.
That’s investing in small-cap dividend stocks.
While small-cap dividend stocks don’t always make for juicy storylines, the fact is that many of the best performers in the stock market today are these little income producers. And if you have the willpower to stick with them, you may easily find their performance rivals that of the best performing growth stocks.
The ugly truth for growth investors is that, so far this year, value stocks are beating growth stocks. And this isn’t just a small-cap phenomenon; large-cap value stocks are beating large-cap growth stocks by 3.3%, while small-cap value stocks are beating their growth counterparts by 4.6%.
Naturally, there are many very good (and very bad) performing stocks from both value and growth camps, so I don’t want you to conclude that value is fundamentally superior to growth. But you have to take note of the trends staring you in the face.
And the fact is, this isn’t a new trend. It’s been going on for decades.
Are Small Caps the Best Dividend Stocks?
Two studies paint a rosy picture of small-cap dividend stock performance. The first, from Ned Davis Research, focused on the period from 1972 to 2012. It concluded that average annual returns for small-cap dividend stocks (around 12.5%) were higher than returns for large-cap dividend stocks (around 7%). Returns for small-cap stocks that initiated dividend payments and grew them over time were even better, averaging annual returns of 20%, versus 12.5% for large caps that also initiated and grew dividend payments.
The second study is probably better known. It’s a 2003 study from Ibbotson Associates that focuses on style indexes data from 1968 through 2002. It concluded that over that timeframe, $1.00 invested in small-cap value stocks would have turned into $104.82, an envious return for any investor. The same dollar invested in large-cap value stocks would have turned into only $29.15, less than one-third of what the small-cap stocks delivered.
There are a host of caveats to taking the results of any study, including these, as fact. For instance, Ibbotson’s study focused on “value” stocks, which doesn’t necessarily mean they all paid a dividend. And both studies were prone to migration error, which is when a stock moves up (or down) from one index to the next.
This is a particularly prevalent problem in small-cap index analysis because, especially over longer timeframes, many good performing small-cap growth (and value) stocks graduate up to a mid-cap index, and possibly even on to a large-cap index (some move down as well).
It’s somewhat ironic that outperformance—the very reason investors should be attracted to small-cap dividend payers (and small caps in general)—can actually hurt the historical performance of the asset class over the long term. But that’s just the way it goes when you’re using historical data.
And the fact that small-cap dividend stock performance is strong enough to overcome the upward migration error is just one more reason to consider them in your portfolio. One way to get around that issue, and possibly capture the greatest amount of upside, is to simply go with individual small-cap dividend stocks. Here are three worth a look.
3 Small-Cap Dividend Stocks to Buy Now
MGP Ingredients (MGPI) is quite possibly the least known food and beverage company in the U.S. The company makes food ingredients (specialty wheat proteins and starches) and distilled spirits (bourbon, whiskey, vodka and gin). With the spirits business making up nearly 90% of revenue, it’s really in the business of making alcohol. And that business is about as steady as they come.
The company is far from being a growth stock (revenue growth in 2015 was 4.5%), but it has been a long-time dividend payer and has been increasingly profitable since re-focusing its business in 2013. Last year it delivered EPS of $1.48, and was also added to the Russell 2000 Small Cap Index.
Even though its market cap is a mere $450 million, MGP Ingredients is the largest supplier of rye whiskey and distilled gin in the U.S. And with consumer demand picking up for premium and craft spirits, the company is introducing its own branded products to try to capture a slice of this high-margin business.
Its newest offering, the limited edition Metze’s Select Indiana Straight Bourbon Whiskey, launched in the third quarter of 2015 at $75.00 a bottle. The shift in business is best seen in MGP’s profit margins (not revenue growth), as Q1 2016 gross margin is already up 5.6% over the same period in 2016. The stock is up too, by 10.2% so far this year. It pays an annual dividend of $0.08, which isn’t much, but it’s growing. Remember that Ned Davis study I mentioned?
Kadant (KAI) is an industrial company that makes equipment and consumables for making paper and engineered wood. Like many industrials, it’s not a particularly interesting company.
But the stock has more than doubled over the last four years and has been on fire in 2016, rising 29% year-to-date.
So it might be worth looking past the details of Kadant’s pulping, filtration, condensing and chipping equipment and focusing more on stock performance. And, of course, dividend payments and share repurchases.
The stock yields 1.6% today, and management has increased the dividend from $0.125 per quarter in 2013 (when it initiated the dividend) to $0.19 per quarter today. Management has also just re-upped the $20 million share repurchase plan that was set to expire on May 18, 2016. They had repurchased $5.9 million worth of stock, but now have another $20 million to go. Kadant has a market cap of $530 million.
Elbit Systems (ESLT) is a defense contractor, though some of its technologies are finding their way into consumer goods. It recently spun out a company called Everysight, which is making wearable technologies for consumers. The first product is a set of augmented display smart glasses designed for cyclists.
Elbit does a lot of things. It is the market leader in advanced fighter jet and rotary wing helmet-mounted display systems. It is the world’s largest manufacturer of drones. It makes components for aircraft, helicopters, tanks and other land-based vehicles. It makes flight simulators. And it’s also the largest electro-optics company outside of the U.S., making devices for gathering intelligence, identifying targets and protecting soldiers for the U.S. Marines, the U.S. Navy, NATO forces and the Israel Defense Forces. In other words, if it can swim, fly or roll, Elbit Systems probably makes it better.
The company is a modest grower, but is profitable and pays a dividend of 1.8%. It’s up 6.5% so far in 2016.
I don’t tend to go out searching for small-cap dividend stocks for inclusion in Cabot Small-Cap Confidential 2.0. We’re not looking to benefit from the law of averages, but rather to hold the select small-cap stocks that crush the market and pull up the returns of any index they belong to. But occasionally, one of my selections does pay a dividend. It’s usually a company that generates so much cash, it can afford to give a little back to investors, even after paying for acquisitions and internal R&D.
This was the case last month, when I added a dividend-paying medical device company to the portfolio.
If you’re interested in getting the details on this company, you can learn more here.