Small-Cap Stocks With High Yield: What Could Go Wrong?

Well, a lot actually. Find out how to avoid the pitfalls.

   
Small-Cap Stocks With High Yield: What Could Go Wrong?

A low-priced small-cap stock with a dividend can look quite tempting to the inexperienced. That lower price should mean a higher yield, plus the chance for growth, right?

Wrong.

Small-cap stocks that offer a dividend instantly put me on the alert. If a company has less than $2 billion in market capitalization, typically it does not offer a dividend because it’s reinvesting every dime of profits back into the company. It’s still trying to grow organically from infancy to become a midcap and eventually a large-cap stock.

When you do find a small-cap stock that offers a dividend, it’s typically a “sinking ship” kind of situation. Companies like that have lost their fundamental growth story and are desperate for investor interest, so they’ve turned their stock into an income idea just to keep money coming in the bank.

Beware Return of Capital

If you do find a small cap that pays a dividend, it’s likely at risk for return of capital — meaning the money you buy the stock with is essentially returned to you in the dividend payment.

One example is the BlackRock Enhanced Capital and Income Fund (CII). Last July, a subscriber asked me if this closed-end fund might be a good addition to the Cash Machine portfolios; at the time, it had an 11.55% yield and was trading at a 7.17% discount to NAV. Sounds tempting, right? Well, I dug in and found out that the fund’s dividend had been paid primarily from ROC. That told me that CII wasn’t even close to earning its payout.

Many assets only depreciate as they attempt to maintain dividend payouts that aren’t supported by real fundamentals. It doesn’t make sense to invest in an entity that’s struggling to make dividend payments as well as capital gains. Therefore, I suggest you always avoid investments that pay out their dividends in the form of return of capital.

2 Ways to Combine Income and Growth in Small-Caps

One smart way to collect income plus growth on the small-cap market is to find a small-cap index fund that has a liquid option chain, and to sell covered calls on it. A good one would be the Russell 2000 Index ETF (IWM). By purchasing the ETF, you’re getting the risk/reward of small caps, but you can generate income with the premium from your covered calls.

The risk here is that the Russell 2000 has a 1.2 beta over the overall market — meaning it’s 20% more volatile, and could react more strongly to the downside than the overall market would. However, if you think the economy is going to grow 1% to 3% over the next few months (as I do), then aside from these bouts of volatility, that would be a constructive way to play the entire small-cap world.

But if you’re not interested in trading options, occasionally you can find a small-cap real estate investment trust, business development company or master limited partnership. REITs, BDCs and MLPs are companies with specialized tax structures that are required by law to pay out 90% of their earnings as dividends. So in this case, I wouldn’t be alarmed by a high payout — even if it has a small market cap.

However, as you might imagine, stocks like these are few and far between. One that I’m recommending to my subscribers is Full Circle Capital (FULL). This $59 million market cap stock is a closed-end business development company that collects income via debt and equity investments in small businesses. I like the technical setup here, and it’s a monthly payer with an annual payout of 92 cents per share, currently yielding 11.7%.

Bryan Perry is editor of Cash Machine, a newsletter focused on dividends and income investing. His newest service, Extreme Income, also focuses on dividend investing with “income boosters” like momentum plays, option strategies, and more.


Article printed from InvestorPlace Media, http://investorplace.com/2013/06/small-cap-stocks-with-high-yield-what-could-go-wrong/.

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