Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Small-Cap Dividend Stocks Offer High Yields Without High Risk
Transcript
- Lucas: If you look at the Russell 2000 over the past week, it's down about two and a half percent. The S&P 500 is down nearly three. But here's what caught my eye — Realty Income, ticker O, is up more than two percent in that same stretch. That's a $60 stock yielding almost six percent. Luna: So small-cap and mid-cap dividend payers are actually holding up better than the broader market right now? Lucas: Exactly. And I think there's a real opportunity there. Most dividend investors gravitate toward the usual suspects — Procter and Gamble, Johnson and Johnson, Coca-Cola. And those are great companies. But with the 10-year Treasury at four point four seven percent, a stock like PG yielding around two and a half percent doesn't look as compelling. Luna: Right, the yield spread is pretty thin. So where are you finding better yields without taking on junk-bond risk? Lucas: I've been screening for small-cap and mid-cap stocks with dividend yields above four percent, payout ratios below sixty percent, and positive free cash flow. That combo tells me the dividend is sustainable and has room to grow. A lot of regional banks fit this profile — they're out of favor because of the regional banking scare a couple years ago, but many have solid balance sheets now. Luna: It's interesting because when the Fed holds rates steady, like they have at three point six three percent, regional banks actually benefit from the stable net interest margin. Lucas: That's the key insight. With the Fed funds rate flat, and the yield curve still positively sloped — the 10-year is at four point four seven, the 2-year at four point zero five — banks can borrow short and lend long at a healthy spread. So their earnings power is decent. And some of them are paying out forty to fifty percent of earnings in dividends. Luna: Can you give a specific example? I think listeners want something concrete to look at. Lucas: Sure. One name I've been watching is a regional bank in the Southeast, around a $5 billion market cap, yielding about four point eight percent. Payout ratio is fifty-two percent. Free cash flow yield is over seven percent. They've raised the dividend every year for the past nine years. That's not a household name like Bank of America, but the dividend growth trajectory is real. Luna: And you're not taking on huge risk because the payout ratio is conservative. That's the opposite of a yield trap. Lucas: Exactly. A yield trap is when the payout ratio is over ninety percent and the company is borrowing to pay the dividend. What I'm talking about is a company generating more cash than it needs, and sharing that with shareholders in a disciplined way. Luna: Now, Realty Income is a different story — it's a triple-net lease REIT, so it's required to pay out most of its earnings. But its payout ratio based on adjusted funds from operations is around seventy-five percent, which is reasonable for a REIT. Lucas: And Realty Income has actually been a beneficiary of the rising rate environment because they've been able to acquire properties at higher cap rates. That's why the stock is up two point two percent in a down market. But I'd argue the bigger opportunity is in the smaller names that aren't as widely covered. Luna: What about the industrial REITs? Some of those are mid-cap and yield over five percent. Lucas: Absolutely. Industrial REITs that own warehouses and distribution centers are seeing strong demand from e-commerce and supply chain reshoring. One mid-cap industrial REIT I follow yields five point three percent, payout ratio around seventy percent of AFFO, and they've grown the dividend at a compound annual rate of about six percent over the last five years. Luna: So the key is to look beyond the big names. The S&P 500 has been driven by mega-cap tech, but that's not where the dividend income is. Lucas: Right. In fact, the Nasdaq is down over five percent in the past five days. If you're a dividend investor, you don't need to chase that volatility. You can find steady income in smaller, well-run companies that are off the radar of most analysts. Luna: But screening for these names takes time. What's your process? Lucas: I start with market cap between one and ten billion dollars. Then I filter for dividend yield above three percent. Then I look at payout ratio — below sixty percent for non-REITs, below eighty percent for REITs. Then free cash flow yield above five percent. And finally, at least five consecutive years of dividend growth. That narrows the universe to maybe a hundred stocks. Luna: And from there you do fundamental analysis on each one. Lucas: Exactly. Look at debt to equity, interest coverage, revenue trends. But the screen saves hours. And I think the current environment — with the 10-year around four point five percent and the Fed on hold — is actually ideal for this kind of hunting. Bonds aren't giving much more than four and a half percent, but a small-cap dividend stock with four and a half percent yield and six percent dividend growth gives you a total return potential of over ten percent. Luna: That's the power of dividend growth. You get the yield plus the compounding. Lucas: And the valuation is reasonable. Many of these stocks trade at 12 to 15 times earnings, compared to 20-plus for the S&P 500. So you're not overpaying for the income. Luna: If today's episode gave you a new angle to think about your portfolio, I want to mention something. The reason we can have these conversations without ads is that listeners who find them useful sometimes choose to support the show. Lucas: It's a small way to keep this going. If you'd like to be part of that, you can go to buy me a coffee dot com slash fexingo. No pressure at all — we're just glad you're here. Luna: Exactly. Now back to small-cap dividends — one risk I want to flag is liquidity. Some of these smaller stocks can be thinly traded. Lucas: That's a real concern. If you're buying a stock with a market cap under two billion, the bid-ask spread can be wide, especially during market stress. So I'd recommend using limit orders and not trying to trade in and out. These are buy and hold positions for income, not trading vehicles. Luna: And diversification matters. Don't put all your small-cap dividend allocation into one stock. Spread it across sectors — maybe a regional bank, an industrial REIT, a consumer staple, and a utility. Lucas: That's a solid approach. And if you don't want to pick individual stocks, there are ETFs that focus on small-cap dividends. But the expense ratios can eat into the yield, and you lose the ability to avoid the weakest holdings. Luna: So for the DIY investor, the screen we talked about is a good starting point. Lucas: I'd say start with that screen, then read the most recent annual report. Look at the dividend history. Check if the dividend was cut during 2020 or 2022. If it held up through those periods, it's probably resilient. Luna: Great advice. And as always, do your own research or talk to a financial advisor. Lucas: Exactly. Next time we'll dig into how to evaluate dividend safety in small caps using free cash flow coverage ratios.