Dividends Are a Sign of Quality and Corporate Commitment

Jay Kaplan

You manage two mutual funds that focus on dividend-paying companies. As a small-cap investor, what appeals to you about dividends?  

At Royce, we like dividends for a lot of reasons. Not the least of which is that we see them as a measure of quality. We also think they are an indicator of responsible corporate governance. This is not necessarily a mainstream philosophy. In the small-cap world, dividends are often underappreciated; while about a quarter of micro-cap, small-cap and mid-cap companies currently pay dividends, only four of Morningstar's 553 small-cap objective mutual funds focus on them.* And Royce Total Return Fund and Royce Dividend Value Fund are two of those four.

It's important to understand, though, that when we look for dividends, we are not just looking for yield.  Our goal is to deliver a total return within the context of Royce's core philosophy of strong balance sheets, high returns on capital, and owning businesses at discounts to their intrinsic values, but to do it using companies that also pay a dividend.

We are not in the business of creating a high yield for investors. To do that, we would need to consider master limited partnerships, real estate investment trusts, and utilities, which are generally not consistent with our investment philosophy. We are not interested in companies that are leveraged or where returns are too low. Another problem with chasing yield is that you often find it in companies that are troubled and pay dividends that they can't afford. With these kinds of companies, there is a high risk that those dividends will go away.

Do dividend-paying companies tend to perform as well as non-dividend payers?

Surprisingly, small-cap dividend payers have performed better, particularly over long-term periods. We recently did a study going back as far as there is reliable data—to 1993—and found that dividend-paying small-caps within the Russell 2000 Index outperformed their non-dividend paying counterparts for the entire period. (The average annual total return for the period of 18 calendar years ended 12/31/10 was 10.6% for small-cap dividend payers versus 7.0% for those that do not.)

[Read "Dividends: Our Ongoing Love Affair" Royce's whitepaper on dividend-paying small-cap stocks.]

These stocks tend to perform well in low return environments, and less well in high return environments. Why is that?

Dividend-payers tend to be more mature companies, in conservative, lower-beta businesses, and their stocks tend to be less volatile. In raging bull markets, they tend not to get as hot as the rest of the market. And the inverse is often true: when the market heads south, they tend not to travel down as far. Another way to put it is this: boring is good. In an ideal world, we would love to buy a portfolio of stocks that we could own for ten years. Our business doesn't really work like that, but that's kind of our goal.

History has shown that if you have better downside performance vs. the benchmark—even if you sacrificed some performance in the big up markets—your risk-adjusted returns should be really satisfying over full market cycles [see Russell 2000 Trough To-Peak Cumulative Returns and Russell 2000 Peak-to-Trough Cumulative Returns]. Our goal is to generate above-average absolute returns over full market cycles with less volatility.

Royce Total Return Fund (RTR) and Royce Dividend Value Fund (RDV) share a fair amount of common ground: Both invest for long-term capital appreciation, and focus on dividend-paying smaller-company stocks. How are the two Funds different?

RTR is a more established, and larger portfolio than RDV, and has been around for 17 years. RDV is smaller, and currently holds a larger percentage of non-U.S. stocks than RTR.

How important is it that a company has a capital allocation plan?

A capital allocation discipline is central to what we do and what we look for. Investors entrust us with their capital, and it is our fiduciary responsibility to allocate it in the most thoughtful and responsible way possible. In turn, we give that capital to corporate management teams that we believe will be responsible stewards and effective allocators of capital. When they generate free cash flow, managements can make a number of decisions: they can reinvest in their businesses, pay down debt, buy companies, buy back stock, or pay a dividend. Those actions are not mutually exclusive and can be used effectively in various combinations. We think that companies can both pay dividends and grow those dividends over time. We are interested in companies that develop effective capital allocation plans and are thoughtful about how they spend that capital.

Although Royce is clearly fond of dividends, are there times when a stock buyback may be better than paying a dividend?

There's no one right answer. In any given situation there are a number of considerations, including the price of the stock and the probability-weighted return that a company expects to receive from the buyback. Part of that calculation includes the fact that they know best what the prospects for their business are, and they can make decisions based on the stock market's assigned value of their business versus what they believe the intrinsic value of their business is. So it really depends.

The practice of paying a dividend is typically a long-term commitment, like a marriage, whereas a stock buy back is more like dating: you can start, you can stop, you can get in and get out at a moment's notice, without that same level of commitment. We think that dividends don't have to be large, but they are a commitment.