Q: Dividends. Â Small caps. Growth companies. Do they go together?
A: More than you might realize. While 80% of stocks in the S&P 500 pay a dividend, about 40% in the Russell 2000 pay a dividend. Many of the dividend payers in the Russell are either utilities or financial institutions. However, as of December 2013, 30% of the growth companies in the Russell 2000 paid dividends.Â
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A dividend can serve as a barometer of a company's health, especially in the small cap universe. Companies that pay dividends make the dividend an important part of their capital strategy. They are likely to have a higher hurdle rate on their investments and less likely to pursue self-aggrandizing projects. Being obligated to a dividend can instill fiscal discipline and cement a commitment to shareholders that is not easily broken. Â
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Q: I thought dividends were a trait of value investing. Â Why are we seeing them in growth equities and the small cap universe?
A:  Historically, dividends and growth investing have not gone together. Philip Fisher wrote Common Stocks and Uncommon Profits in 1958, which defined growth investing. Fisher identified fifteen questions to ask about a company and the first question was, "Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?"  Small cap companies often have opportunities to reinvest their capital in new products or distribution channels, with the potential to earn high returns on that reinvested capital. However, in today's slow growth economy, some small cap companies find it possible to fund both their growth opportunities and dividends.
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Apple (AAPL, Financial), Cisco (CSCO, Financial), Microsoft (MSFT, Financial) and Oracle (ORCL, Financial) are a few large cap growth companies that now pay dividends. These companies have reached a stage where they are nicely profitable and generate enough cash to fund R&D, acquisitions, stock buy-backs and dividends. A decade ago, they were not as profitable.  Approximately 15% of the S&P 500 dividends now come from technology companies versus just 5% ten years ago.
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Examples of small cap technology dividend payers include REIS, Inc. (REIS, Financial), MKS Instruments, Inc. (MKSI, Financial) and Brooks Automation, Inc. (BRKS, Financial)  MKS and Brooks both have semiconductor capital equipment businesses that generate cash. Each has also made significant acquisitions and new product investments that moved them into new markets, all the while paying dividends.
Q:Â Why is a dividend strategy valuable in small cap investing? Â Â
Can investors benefit from the above average growth potential of small cap stocks while dampening the risks associated with volatility and drawdowns?
A:Â We think it's possible for investors to find balance in a strategy that includes small cap stocks with above average growth rates, some of which pay a dividend.Â
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In recent years, companies that paid dividends have outperformed non-payers; however, as a group, companies that have grown their dividends have outperformed the other dividend payers by a wide margin. In the chart below (compiled by Ned Davis Research), it is clear that small cap dividend growers generated higher returns with less volatility.  Growing companies may also be in a position to grow their dividends.
Furthermore, not only have small cap dividend payers had lower volatility compared with the overall small cap universe, they also have lower drawdowns - winning by not losing as much.Â
Source: Â Ned Davis Research
In today's yield-starved investment world, 2-year U.S. Treasuries yield 0.6% and 10-year Treasuries yield 1.0%. Germany, Switzerland and Japan, amongst others, have negative interest rates. And since negative interest rates require the bond holder to pay the issuer for the convenience of holding a bond, the holder is guaranteed to lose money. Against this backdrop, dividends may be an attractive form of income.
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John Barr is a Co-Manager of the Needham Growth Fund (NEEGX). He has been its Co-Manager since January 2010. He also manages the Needham Aggressive Growth Fund (NEAGX). He engages in a variety of portfolio management-related activities, including stock selection, research, company visits and market analysis.
