SMID Selectivity Is Warranted, Could Pay Dividends

Last year, the S&P 500 easily outpaced both the S&P MidCap 400 and S&P SmallCap 600 indexes and that theme has carried over into 2024. As of Feb. 24, the large-cap index is higher by 6.8% while the mid-cap gauge is up 2.9%. The small-cap basket is off 1.5%.

In other words, advisors haven’t had much reason to discuss smaller stocks with clients. However, helped in part by deeply discounted valuations, that tide is turning in incremental fashion. An often cited knock against smaller equities, particularly small-caps, is that they are richly valued compared to large-caps. That’s simply the price of admission for accessing the growth attributes offered by smaller companies.

Beyond diversification and decreasing a portfolio’s dependence on the magnificent seven and related fare, reasons to at least keep an eye on SMID stocks and funds include being ready for the inevitable rebound these names. That preparation should be deployed in judicious fashion. Enter dividends.

The mid/small-cap dividend opportunity is all the more relevant today because, like large caps, mid-size and smaller stocks are slumping. However, dividend and value fare in the SMID camps are outperforming broader benchmarks in these categories, indicating now could be an ideal time to evaluate smaller dividend payers on behalf of risk-tolerant clients.

The Case for SMID Right Now

As noted above, there are compelling valuation and concentration cases for smaller stocks. Not only are the largest holdings in many standard large-cap indexes richly valued, but those stocks are also accounting for out-sized percentages of those benchmarks.

Then there’s the interest rate factor. Smaller stocks are notoriously tethered to Federal Reserve policy. Should 2023 represent the end of Fed tightening, the stars could be aligning for the SMID category.

“While lower interest rates may benefit companies of all sizes, smaller companies are often perceived to be more negatively impacted by rising interest rates,” according to First Trust research. “Thus, after the Federal Reserve held interest rates steady at its November 1st meeting—and Jerome Powell made comments interpreted by some as hinting at the end of interest rate increases —the S&P MidCap 400® Index and S&P SmallCap 600® Index both rallied, significantly outpacing the S&P 500® Index through the end of the 2023.”

As the asset manager notes, some of the apprehension regarding boosting allocations to smaller stocks is derived from the belief that a recession would be more harmful to SMID than large-caps. Historical data to that effect are mixed.

The S&P 500 beat the the S&P MidCap 400 and S&P SmallCap 600 indexes during the “Covid recession”, but the smaller stock benchmarks beat the large-cap gauge in 2001 recession and the global financial crisis, according to First Trust.

Consider Dividends with Smaller Stocks

Perhaps too often, advisors and clients alike focus on the dividend properties of large-caps while ignoring similar traits within the SMID space. However, some smaller stocks have attractive payout prospects in their own rights and some of those names are accessible in basket firm thanks to the First Trust SMID Cap Rising Dividend Achievers ETF (SDVY).

The $3.28 billion SDVY, which turns seven years old in November, holds 99 stocks that selected based on factors including profitability, recent dividend trends, payout ratio and cash to debt ratio.

“Large-cap indices have become exceptionally top heavy, in our view, and valuations have expanded significantly over the past year, creating more potential downside risk if earnings growth expectations prove to be too optimistic,” concludes First Trust. “Conversely, earnings multiples for small- and mid-cap stocks have remained below longer-term averages. Cognizant of the risks that the economy could weaken this year or that interest rates could remain elevated, we believe that SDVY may be an effective way to increase allocations to high-quality, profitable SMid-cap stocks.”

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