When it comes to investing, bigger isn't always better.
In fact, the opposite is sometimes true. Small-cap stocks outperformed large caps by an annual average of just more than 2% from 1926 to 2006, according to the "Stocks, Bonds, Bills and Inflation" yearbook by Ibbotson Associates.
Though this is just an average, it's clear that overall, small caps are proven top performers for the long term.
Small-cap stocks are defined differently among brokers. Generally, these are companies with a capitalization between $300 million and $2 billion. Anything less than $300 million is generally considered to be a micro-cap or penny stock. Companies with more than $2 billion fall into the mid-cap category. Large caps are generally any company with more than $10 billion in capitalization.
The benefits of small caps
Small-cap stocks provide market outperformance during most economic cycles.
Fidelity Investments Chairman John Bogle conducted a study revealing that small-cap stocks outperform during rising interest rate environments. This is counterintuitive, but shows that interest rates generally increase during times of economic growth. Speaking of economic growth, small caps have a better likelihood of growing rapidly than large caps. This in turn not only leads to share price gains, but dividend raises.
[Combining dividends with growth is one part of the "Dividend Trifecta" strategy Amy Calistri uses in her Daily Paycheck newsletter. Simply put, this strategy multiplies the effectiveness of every dollar you invest. You can learn more here.]
And because small-cap stocks often trade for less than larger-cap stocks, investors are able to purchase more shares with the same amount of capital. But the best thing about small caps is that these stocks often pay attractive dividends. In fact, the combination of small-cap stocks with historically increasing dividends is a very powerful investment strategy. So much so, that this pairing spawned its very own index, the Russell 2000 Dividend Achievers Index.
The power of small caps combined with dividends
To be included in the index, stocks must have at least 10 years of consistent dividend increases, be part of the Russell 2000 Index and have a minimum daily trading volume of 500,000 shares. Of the 2,000 companies in the Russell 2000, only 63 qualify to be in the Dividend Achiever Index. You can see from the illustration below how the Dividend Achievers Index has outperformed the Russell 2000 Index since 2001.
Here are two stocks featured in the small-cap Dividend Achievers Index that I particularly like right now:
The company has paid dividends for the past 35 years and currently yields 3% on a payout ratio of 45% of trailing free cash flow and 82% of trailing earnings. With a trailing 12-month revenue of $3.3 billion, the stock has averaged a 13% return on equity (ROE) for the past three years.
Most interestingly, the company paid a special dividend of $5 per share in October 2012. CEO Albert Nahmad said the special dividend shows management's confidence in the company and its continued ability to generate free cash flow. I particularly like the fact that institutions are the major holder of shares. BlackRock Fund Advisors holds 13% of the stock, while Fidelity Management and Research holds 9%, as the top two shareholders.
As the U.S. housing recovery continues, many heating and air conditioning systems could reach the end of their estimated life span, causing a growing need for products and services this company offers. Technically, shares have been uptrending since the end of July 2012. Price hit resistance at $78 and has just pulled back into the value "buy" zone. This consistent dividend payer is a good pick with a $92, 18-month target price and an initial stop loss at $72.
2. Owens & Minor (NYSE: OMI)
Owens & Minor is a supplier of health care products and third-party logistics supply-chain management services. It serves a network of 4,000 health care providers from 55 distribution centers that are strategically placed across the United States.
This company boasts a market capitalization of $1.9 billion and has paid dividends since 1926. The dividends have increased during each of the past 14 years. In fact, in the past five years, dividends have increased by an average of 14.2%. The stock currently yields 3% and has returned more than $200 million by way of dividends to shareholders in the past several years.
The company has a gross margin of 9.9% and an operating margin of 2.5% with a net of 1.2%. It has a forward price-to-earnings (P/E) ratio of 15.7, below industry average of 17.2. Its price-to-book (P/B) ratio is also lower than peers -- 1.9 vs. 2.8.
Despite the fact that Owens & Minor's 2013 forecast missed estimates of just more than $2 per share with a forecast of $1.90, I like that it just acquired Movianto Group for $158 million. This recent acquisition is likely to facilitate an expansion into the European health care market.
Technically, shares have bounced hard off of the Dec. 1, 2012, lows, hitting resistance in the $30 range. Price has pulled back into the value "buy" zone, creating a good buying opportunity. I like this stock at current levels, with a $35 18-month target and an initial stop loss at $29.
Risks to Consider: Small caps can be very volatile. This volatility can be negative and positive to the stock price. Always be sure to use stops and position size properly when investing.
Action to Take --> This year is shaping up to be a bullish year for stocks in general, and these two small caps are poised to benefit from the upward wave. As I said, buy Watsco between the $74 and $75 range for a price target of $92 in 18 months, and buy Owens & Minor at current levels for an 18-month price target of $35.