Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / Why Dividend Investors Should Watch Small Caps in Late May 2026
Transcript
- Lucas: So the Russell 2000 is up six-point-three percent in the past five days. The S&P 500? Up two-point-three. That gap — four full percentage points — is the widest we've seen in months, and it raises an interesting question for dividend investors: are we ignoring small-cap stocks? Luna: Well, we talk a lot about large-cap dividend aristocrats — Coca-Cola, Johnson & Johnson, Procter & Gamble — but small caps don't usually come up in the same sentence as 'stable income.' Lucas: Right. And that's partly fair: smaller companies tend to have less predictable cash flows, higher debt loads, and a higher risk of cutting dividends during downturns. But the Russell's recent surge — and the fact that the yield curve is still pretty flat, with the ten-year at four-point-five-seven percent and the two-year at four-point-zero-eight — means investors are starting to look beyond mega-cap names for yield. Luna: It's interesting you mention the yield curve, because the spread between the ten and the two has actually narrowed, from forty-nine basis points to forty-three. That's usually a sign of caution, not exuberance. So why would small caps suddenly catch a bid? Lucas: Part of it is rotation. The mega-cap tech names — think NVIDIA, Apple, Microsoft — have had an incredible run. But their dividend yields are tiny: Apple is around zero-point-five percent, NVIDIA maybe zero-point-zero-three. If you're an income investor, you're not getting paid to wait. Meanwhile, the iShares Select Dividend ETF, ticker D-V-Y, which has a meaningful small-cap tilt, is up one-point-seven percent in the same five days and yields around three-point-four percent. Luna: And just to put a finer point on that: the Vanguard High Dividend Yield ETF — V-Y-M — which is mostly large caps, is also up one-point-eight percent and yields about two-point-nine percent. So you're getting more yield from DVY, but with more volatility. Lucas: Exactly. And this is the part where I want to be really specific, because 'small-cap dividends' can sound like an oxymoron. But there are actually plenty of small-cap companies that have raised dividends for ten, fifteen, even twenty years. They just don't get the same attention as the big-name aristocrats. Luna: Let's talk about a concrete example. I was looking at a small-cap real estate investment trust — not Realty Income, which we covered a few episodes back — but a smaller REIT focused on self-storage. It yields about four-point-eight percent, has raised its dividend for twelve straight years, and its payout ratio is around seventy percent. That's actually pretty conservative for a REIT. Lucas: Seventy percent is conservative for a REIT, yeah, because they have to distribute at least ninety percent of taxable income. So a payout ratio below that means they're retaining some capital for growth or debt reduction. That's the kind of metric you want to screen for. Luna: And that's exactly the thing we can do as individual investors, but it's also why we keep this show ad-free — because we want to talk about specific strategies without worrying about sponsor conflicts. If you find value in conversations like this, you can support that choice at buy me a coffee dot com slash fexingo. It's a small way to keep these shows independent. Lucas: Yeah, I appreciate that. And it's true — no ads means we can dig into a small-cap REIT or a niche ETF without anyone telling us to 'stay tuned for a message from our sponsor.' So, back to small caps: the key screen isn't just yield. It's free cash flow yield. A company can pay a dividend today, but if it's borrowing to do it, that's not sustainable. Luna: Right. And the data shows that small-cap dividend payers have actually improved their free cash flow generation over the past two years. According to a recent report from Bank of America, the median small-cap dividend stock now has a free cash flow yield of about five-point-five percent, versus three-point-eight for large caps. Lucas: That's a significant gap. And it suggests that, on a cash basis, small caps are actually cheaper than large caps right now. Of course, you have to be more selective. You can't just buy a small-cap index and expect a smooth dividend ride. Luna: What about the risk of dividend cuts? We saw a lot of small caps cut or suspend dividends during the pandemic. How do you assess that risk today? Lucas: Great question. One metric I look at is the debt to ebitda ratio. If it's above three-point-five, I get cautious. Another is the dividend coverage ratio — that's earnings per share divided by dividend per share. You want coverage above one-point-five, ideally two or higher. A company with coverage of two can afford to maintain its dividend even if earnings drop by half. Luna: And the current environment — with the Fed holding rates steady at three-point-six-four percent on the effective federal funds rate — means borrowing costs aren't falling. So companies with variable-rate debt could see their interest expenses stay elevated. That's a headwind for some small caps. Lucas: It is. But it's also a tailwind for the ones that have locked in low fixed-rate debt or have minimal leverage. The market is starting to reward those companies. Look at the recent price action: the Russell 2000 gained six-point-three percent in five days. That's not just a reflexive bounce. It's a signal that investors believe small-cap earnings can improve from here. Luna: And the dividend side of that story is still underappreciated. The Schwab US Dividend Equity ETF — ticker s c h d — has some small-cap exposure, but it's only about fifteen percent of the portfolio. There's no pure-play small-cap dividend ETF that's widely followed, which means active stock picking can add real value. Lucas: That's a good point. And it's why I think dividend investors should consider allocating maybe five to ten percent of their income portfolio to high-quality small-cap dividend payers. Not for yield-chasing, but for total return with a growing income stream. Luna: Let's pull up a specific small-cap name that checks the boxes. I'm thinking of a company in the industrial sector — it makes components for HVAC systems. Market cap around two-point-five billion. It's raised its dividend for nine consecutive years. Current yield is two-point-nine percent. Payout ratio is thirty-eight percent. debt to ebitda is one-point-eight. Lucas: Those are solid numbers. A payout ratio of thirty-eight percent leaves plenty of room for reinvestment and dividend growth. And with a debt to ebitda under two, the balance sheet is conservative. That's the kind of small cap that could easily become a mid-cap dividend grower over time. Luna: And the stock is up about four percent over the past week, which is actually less than the Russell, so it hasn't been swept up in the broad rally yet. That could be an entry point. Lucas: Exactly. The broad small-cap rally might be just getting started. If earnings season confirms that small-cap profit margins are stabilizing — and early reports suggest they are — then we could see more capital rotate into this space. For dividend investors, the window to get in before yields compress might be now. Luna: One risk I want to flag: small caps tend to have higher beta. If the market turns risk-off because of something like the Strait of Hormuz closure pushing oil prices higher, small caps could sell off more sharply than large caps. So position sizing matters. Lucas: Absolutely. And that's why I'd frame this as a tactical allocation, not a permanent shift. If you're a long-term dividend growth investor, you probably already have a core holding in something like VYM or SCHD. Adding a small-cap dividend sleeve can enhance yield and growth potential, but you need to monitor it more actively. Luna: What's your preferred vehicle for someone who doesn't want to pick individual small-cap dividend stocks? Is there an ETF you'd recommend? Lucas: I'd look at the iShares Select Dividend ETF — DVY — which we mentioned earlier. It has about thirty percent in small and mid caps combined. Its top holdings include utilities and financials, which tend to be reliable dividend payers. The expense ratio is thirty-nine basis points, which is reasonable for an actively managed index approach. Luna: And the yield on DVY is around three-point-four percent, which is competitive with the ten-year Treasury at four-point-five-seven percent when you factor in dividend growth potential. The Treasury gives you a fixed coupon; a dividend stock can increase its payout over time. Lucas: That's the key distinction. A bond's yield is locked in at purchase. A dividend stock's yield on cost can grow. If you buy a small-cap dividend payer with a two-point-nine percent yield and it grows its dividend at ten percent annually, your yield on cost will be over four percent in five years. That's hard to beat with fixed income. Luna: And we should note that the thirty-year Treasury yield has actually ticked down slightly — from five-point-eleven to five-point-one zero percent — so the long end is suggesting that inflation expectations are moderating. That's favorable for dividend stocks, especially those with pricing power. Lucas: Good point. If long-term rates stay below five-point-two-five percent, dividend stocks become more attractive on a relative basis. And small caps, with their higher growth potential, could benefit disproportionately. Luna: So to sum up: small-cap dividend stocks are having a moment, but they require more due diligence. Focus on payout ratio, free cash flow, and debt levels. Consider a fund like DVY for diversified exposure, or pick individual names if you have the time and risk tolerance. Lucas: And remember, the Russell 2000's six-point-three percent move is a reminder that markets can shift quickly. Dividend investors who ignore small caps might be leaving yield and growth on the table. But as always, don't chase performance — build a plan and stick to it. Luna: Next time, we'll look at how the oil price spike from the Strait of Hormuz closure is affecting energy dividends. Some of those yields are getting very interesting. Lucas: Looking forward to it. Until then, keep your dividends growing.