If you need income from your portfolio and can't afford to live on the tiny returns that safe investments like Treasuries and bank CDs offer right now, buying dividend stocks gives you your best opportunity to meet your financial goals. But with so many investors interested in the well-known big-name dividend stocks that everyone's familiar with, you might be nervous about being the last to join a growing craze.
But that doesn't mean you should give up on dividend stocks entirely. Although they're somewhat rarer than their bigger counterparts, several smaller stocks carry attractive yields for shareholders -- and since they're further off the beaten path among dividend investors, these small stocks could give you a better chance at scoring the combination of solid income and great growth prospects that represent the holy grail for many investors.
Later in this article, I'll give you the names of several small dividend stocks with some great future prospects. But first, I want to take a look at why you don't often think of small-cap stocks when you're looking for dividend income.
Why most small stocks don't pay
When most investors think of dividends, they focus on big companies with mature businesses that generate huge amounts of cash. Since these companies have plenty of cash on hand and don't tend to be big innovators that have much need to invest their cash internally, they tend to reward shareholders with hefty dividend payments. In fact, over the years, these megacap companies often increase their dividends, making dividend growth the most compelling factor for their investors.
Small companies, on the other hand, often need their cash to plow back into their still-growing businesses. With most small companies struggling to grow amid competition and tough economic conditions, making sure they have access to the capital they need takes top priority. That makes most small companies less willing to give up their cash by paying dividends to shareholders. But when you do find small- and mid-cap companies willing to pay dividends, you know you've found something special.
Exceptions to the rule
As I did with international stocks last week, one great method I like to use to discover good prospects is to scan through popular exchange-traded funds for investing ideas. In this case, the WisdomTree SmallCap Dividend ETF (DES) uses a methodology that weights small-cap companies by their dividend payout. Here are the top stocks with the largest weighting in the ETF:
Trailing Dividend Yield
Weighting in ETF
Medical Properties Trust
National Health Investors
Source: WisdomTree; Yahoo! Finance.
As you can see, these companies all pay out quite respectable dividends. But you'll want to note that many of these companies aren't directly comparable to ordinary dividend-paying stocks. For instance, Medical Properties Trust, Potlatch, and National Health Investors are all real estate investment trusts, which require dividend payments in order to obtain tax benefits. So since they're forced to pay dividends, they shouldn't get as much credit as companies that voluntarily pay them. Similarly, Solar Capital is a business development company, while Prospect Capital does private equity and mezzanine financing for up-and-coming businesses. Only electric and gas utility UIL and tobacco company Vector have ordinary operating businesses, and they reflect the fact that stocks in certain industries are much more likely to pay dividends than others.
That said, if it's income you want, these stocks can definitely deliver. And despite their relatively small size, they're likely to keep paying those dividends -- to a greater or lesser extent -- well into the future.
Win big by thinking small
Many of the conservative investors who tend to gravitate toward dividend investing avoid smaller companies in the belief that they're inevitably riskier. But small-cap dividend stocks can serve the dual purpose of diversifying your portfolio while still giving you the income you need. With two strong arguments in favor of them, you shouldn't count out small companies in your search for the best dividend stocks.
Dividend stocks are changing the rules of investing. To see some smart dividend stocks that could deserve a place in your portfolio, be sure to check out the Fool's free special report, "13 High-Yielding Stocks to Buy Today."
Fool contributor Dan Caplinger likes big rewards in small packages. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is its own reward.