Smaller stocks paying dividends are generally more mature and profitable, a welcome find for retirees in search of new sources of investing income in retirement. By Eleanor Laise, Senior Editor February 13, 2018From Kiplinger's Retirement Report Interested in dividends? It may be time to think small. Dividends of any sort can help deliver relatively steady returns and reduce your portfolio’s overall risk. But dividend investing’s benefits may be even greater in smaller companies than in larger firms, recent research suggests. SEE ALSO: 50 Dividend Stocks You Can Count On in 2018 Although they’re often overlooked by income investors, small-cap dividend payers give investors a bigger performance boost than large-cap dividend payers, according to a 2016 study in the Financial Analysts Journal. (Small caps are companies whose publicly traded shares have a relatively small market value—often in the range of a couple hundred million to several billion dollars, though exact definitions vary.) A focus on dividends also helps tame the risks inherent in investing in smaller, less established companies. While smaller companies tend to be volatile, those that pay dividends are generally a bit more mature and profitable, so adding a dividend focus to your small-cap holdings “helps you weed out the less profitable names,” says Alex Bryan, Morningstar’s director of passive strategies research for North America. Small caps also offer diversification benefits, in part because they tend to generate most of their revenues in their home markets, whereas large multinational companies’ fortunes are tied to the global economy. Adding a dividend focus to small-cap holdings isn’t without risks. One potential pitfall: overloading on a handful of sectors. Many small companies don’t pay dividends because they need their cash to grow the business—and those that do make regular payouts tend to be concentrated in certain sectors such as financials. Seeking out dividends may also lead investors toward “value” stocks—those that appear underpriced relative to their earnings or other fundamentals. Such holdings may underperform the broader market when growth stocks are in favor, as they have been in recent years. Advertisement Many investors associate small companies more with growth than income. Indeed, at the end of 2017, only about half of companies in Standard & Poor’s SmallCap 600 index paid dividends, compared with 83% of the large companies in Standard & Poor’s 500-stock index. But the yields of small-cap dividend payers are competitive: They averaged 2.25% at year-end, according to Standard & Poor’s, compared with 2.24% for large caps and 2.06% for mid caps. And over the long haul, small-cap dividend investing can pay off handsomely. From 1962 to 2014, focusing on dividends when selecting small caps boosted returns by about 5 percentage points annually, the Financial Analysts Journal study found. Large-cap investors got a much smaller performance boost by focusing on dividends over that period. But across the market-cap spectrum, investors substantially lowered their risk by focusing on dividend payers. Avoid dividend stocks and funds with the very highest yields. “Extreme” dividend payers—those whose dividend yields fall in the top 5% of their category—tend to lag behind those with more moderate payouts, the Financial Analysts Journal study found. “The only way to earn a high rate of return is to take on a bit more risk,” Bryan says. Selecting Small-Cap Dividend Stocks Rather than focusing on dividend yield alone, a winning formula for picking dividend stocks combines a decent yield, dividend growth and a low “payout ratio”—the percentage of earnings that the company pays out as dividends, according to Cirrus Research, an independent research firm in Tarrytown, N.Y. A low payout ratio signals that a company can maintain its dividend even if its earnings take a hit—and that it may have room to grow its dividend in the future. Advertisement While a cocktail of robust yield, dividend growth and low payout ratio works well in the large-company universe, it works even better in small caps, says Pankaj Patel, managing director at Cirrus. A portfolio of small caps that meet these criteria gained 18.8% annually from 1995 to late 2017, Cirrus found, compared with 11.6% for mid caps and 13.8% for large caps. The small-cap dividend portfolio beat the broader small-cap universe by 8.6 percentage points annually and yields 2.3%, compared with a 1.6% yield for the small-cap index, according to Cirrus. One of the small-cap companies with sustainable dividends that Cirrus currently finds attractive is Penske Automotive Group (PAG, recent price $52), which operates car and truck dealerships across the U.S., Canada and western Europe. The stock yields 2.4% and trades at 11 times analysts’ estimates of earnings for the coming year. Trinseo (TSE, $79, dividend yield 1.7%), a maker of plastics and latex, and discount retailer Big Lots (BIG, $57, 1.7%) also top Cirrus’s list of small-cap dividend payers. Spread Small-Cap Bets with ETFs For broader diversification among small-company dividend payers, consider a low-cost exchange-traded fund. WisdomTree U.S. SmallCap Dividend Fund (DES) holds about 750 small-cap dividend payers. The fund tracks an index that weights its constituents based on the percentage of total index dividends each company pays—so a company paying $100 million in dividends would get double the weighting of a company paying $50 million. “That causes the portfolio to rebalance into stocks as they become cheaper relative to their dividend,” Bryan says—a contrarian approach that helps the fund buy low and sell high. The WisdomTree ETF avoids overloading on certain dividend-heavy sectors, such as financials, by capping sector allocations at 25% of assets. Over the past 10 years, the fund has gained 10.9% annually, beating roughly 75% of its competitors in the small-cap value category, according to Morningstar. The ETF yields 2.9% and charges annual expenses of 0.38%. SEE ALSO: 6 Best Dividend ETFs for Blue-Chip Income There are few competing small-cap dividend ETFs with long-term track records. But the field is growing. ProShares Russell 2000 Dividend Growers (SMDV), launched in 2015, focuses on companies in the Russell 2000 Index that have boosted dividends for at least 10 consecutive years. The index weights holdings equally and caps exposure to any single sector at 30%. The ProShares ETF yields 1.8% and charges fees of 0.4% annually. First Trust SMID Cap Rising Dividend Achievers ETF (SDVY), launched late last year, tracks the Nasdaq U.S. Small Mid Cap Rising Dividend Achievers index, which includes 100 small and midsize companies with moderate payout ratios—under 65%—and a history of raising dividends. The fund charges annual fees of 0.6%.