Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Dividend ETFs Are Banking on Small Caps
Transcript
- Lucas: If you looked only at the S&P 500 this week, you'd think nothing much happened. Up three-tenths of a percent in five days. But the Russell 2000, the small-cap index, jumped over three percent. That's a ten-to-one gap. Luna: Yeah, that's a big divergence. And we're seeing it play out in dividend ETFs too. DVY, the iShares Select Dividend ETF, up almost three percent. SCHD, the Schwab U.S. Dividend Equity ETF, up one point six. VYM, the Vanguard High Dividend Yield ETF, lagging a bit at one point four. Lucas: Right. And the interesting thing is that DVY has a heavy small-cap tilt compared to VYM. DVY's top holdings include things like utilities and regional banks—companies that are more economically sensitive and have higher yields. When the market rotates toward value and smaller names, DVY tends to pop. Luna: So is this just a rotation trade, or is there something fundamental behind it? Lucas: I think it's partly rotation, but there's a fundamental story too. The ten-year Treasury yield dropped from four point five five percent to four point four five percent in the last week. When yields fall, bond proxies like utilities and REITs become more attractive. Realty Income, ticker O, was up four and a half percent this week. That's a big move for a triple-net lease REIT. Luna: And O is in DVY, right? Lucas: It is. DVY holds a lot of REITs and utilities. But the other piece is that small caps generally have more room to grow their dividends. A company like Realty Income has raised its dividend for over 25 years, but the yield is around five and a half percent. A smaller company might yield six or seven percent with a lower payout ratio, meaning more room for increases. Luna: That payout ratio point is key. If a company is paying out 80 percent of earnings as dividends, there's not much buffer if earnings dip. But a small cap paying out 40 percent has a lot more flexibility. Lucas: Exactly. And that's where free cash flow comes in. Some small caps generate strong free cash flow but have low dividend payout ratios because they're reinvesting in growth. If they decide to return more to shareholders, they can boost the dividend quickly. That's the kind of setup that dividend growth investors love. Luna: So how do you find those names? Are there ETFs that specifically target small-cap dividend growers? Lucas: There are a few. The WisdomTree U.S. SmallCap Dividend fund, ticker DES, is one. It holds about 600 small-cap stocks that pay dividends. The yield is around three percent, but the dividend growth rate has been solid. Another is the ProShares S&P 600 Small Cap Dividend Aristocrats ETF, ticker SMDV, which holds companies that have increased dividends for at least 20 years. That's a smaller fund, but it gives you exposure to names like Farmers & Merchants Bancorp and Kadant. Luna: SMDV sounds more like a dividend-growth play than a high-yield play. Lucas: Right. And that distinction matters. This week, DVY outperformed because it's higher yield and more rate-sensitive. But if we're in an environment where the economy slows and the Fed eventually cuts rates, dividend growth names might do better. The Fed funds rate is still at three point six three percent, but it's been flat. The market is pricing in cuts later this year. Luna: And the yield curve is still inverted, just barely. The ten-year minus two-year spread is thirty-nine basis points, down from forty. That's still negative, but trending toward normal. Historically, when the curve steepens, small caps and value stocks tend to lead. Lucas: That's exactly the pattern we're seeing. And it's why I think dividend investors should be looking at small caps right now. The Russell 2000 is still down from its highs in 2021, so valuations are reasonable. Many small caps have been neglected while megacap tech stocks dominated. But as the market broadens out, those dividend-paying small caps could be the ones that catch up. Luna: Let's talk about a specific example. You mentioned utilities. Utilities are traditionally dividend stocks, but they're not small caps. However, there are smaller utility companies like Avista or Northwest Natural that have yields around four to five percent and payout ratios around 60 percent. They're not as well-known as Duke or Southern, but they have a long history of dividend increases. Lucas: Avista, ticker AVA, is a good example. It's a regulated electric and natural gas utility in the Pacific Northwest. Market cap around three billion. Dividend yield about four point eight percent. Payout ratio around 65 percent. It's increased its dividend for over 20 years. That's a classic small-cap dividend growth stock. Luna: And it's not in DVY, but it might be in something like SMDV or DES. Lucas: Exactly. The challenge for individual investors is that it's hard to screen for these names. That's why ETFs are useful. But if you're building a portfolio, you can take a barbell approach: core holdings in a broad dividend ETF like VYM or SCHD, and then a small-cap allocation via DES or SMDV. Luna: One thing to watch, though, is the payout ratio in small caps. Some of these companies are more cyclical. If the economy slows, earnings could drop, and the payout ratio could spike. That's when dividends get cut. Lucas: Right. The dividend safety rule is: yield times payout ratio. If the yield is 5 percent and the payout ratio is 50 percent, the implied earnings yield is 10 percent. That's a healthy cushion. But if the payout ratio is 80 percent and the yield is 5 percent, the earnings yield is only 6.25 percent. That's thin. Luna: So what's the one number you'd look at this week to gauge small-cap dividend health? Lucas: Free cash flow yield. Free cash flow divided by market cap. A small cap with a free cash flow yield of 8 percent and a dividend yield of 3 percent is in great shape. They can easily cover the dividend and reinvest. If the free cash flow yield is only 4 percent and the dividend yield is 3 percent, they're paying out 75 percent of free cash flow. That's riskier. Luna: And we have the data to check that. Could you give an example from this week's movers? Lucas: Take a look at Altria, ticker MO. It's not a small cap, but it's a high-yield stock that was flat this week, up only 0.9 percent. Its free cash flow yield is around 9 percent, dividend yield around 8 percent. That's a high payout ratio but still covered. Compare that to Realty Income, which has a free cash flow yield around 6 percent and a dividend yield around 5.5 percent. That's more conservative. Luna: And O was up 4.5 percent this week, so the market rewarded that safety. Lucas: Exactly. Now, among small caps, you can find free cash flow yields of 10 percent or more. That's where the opportunity is. The key is to avoid the traps—companies where the dividend is high but the free cash flow is declining. Luna: So for listeners who want to act on this, what's the simplest move? Lucas: I'd say if you already own a dividend ETF like VYM or SCHD, consider adding a small-cap dividend ETF like DES or SMDV. That gives you exposure to the rotation without stock-picking risk. And keep an eye on the payout ratio and free cash flow yield of any individual stocks you buy. Luna: One more thing—before we wrap, I want to mention something that's been on my mind. We talk a lot about dividend investing on this show, and I know many of you listen while you're doing research or even while you're working. If you've found value in these conversations, we'd love your support. The show is ad-free, and it's supported entirely by listeners. You can buy us a coffee at buymeacoffee dot com slash fexingo. That's buymeacoffee dot com slash fexingo. It helps us keep going, and we really appreciate it. Lucas: Yeah, absolutely. And it's completely optional—we're not going anywhere. But if you want to chip in, that link is there. Now, back to small caps. One thing I want to emphasize is that this rotation might have legs. The Russell 2000 has been underperforming for years. If we get a few more weeks like this, dividend investors who ignored small caps could miss out. Luna: And the data from this week suggests momentum is building. DVY's 2.9 percent gain is the best among the major dividend ETFs. That's a signal. Lucas: It is. And with the ten-year yield at four point four five percent, dividend stocks are still competitive with bonds. The spread between the dividend yield on the S&P 500, around one point three percent, and the ten-year is over three hundred basis points. But for small-cap dividend stocks, the average yield is closer to three percent. That's a much tighter spread, which means the income is more meaningful. Luna: So the takeaway for this week: watch the small caps, check the payout ratios, and consider adding a small-cap dividend ETF if you haven't already. Lucas: And we'll keep tracking this rotation. Next week, we'll look at how the financial sector dividend stocks are performing, especially regional banks, which are heavily represented in small-cap indices. Luna: Sounds good. Thanks for listening, everyone.