The reality of stock market investing is that any share is only worth the amount of money you get in the end.  This money can only come from one of two sources: through the eventual sale of the share and/or through dividends.

While selling an investment depends on bids to buy it, market liquidity and it attracts both expensive tax and brokerage consequences, dividend flows from a share come at little to no cost and do not involve exiting the investment. 

The latter point is perhaps the most important attribute of dividends, as while investors can profit in the short term from dividends declared by a share they can also continue to enjoy capital appreciate from future growth in company profits and the share price.

The problem is that not all companies actually declare dividends. While most blue chips and many mid caps have stable dividend policies in place, a lack of dividend payments to its shareholders is often a symptom of small caps.

Dividend theory dictates that if a company could generate a better return on its own reinvested earnings than shareholders could generate for themselves, then no dividend should be declared and the earnings reinvested into the business.  For this reason many growth companies (of which many small caps claim to be) do not declare dividends.

Despite this, a share that does not declare any dividends to its shareholders with the promise of future growth is subject to two major effects:

Firstly, its shareholders will only realise a cash return on their shares when they sell it.  While this can lead to slightly better liquidity in a small caps share, it does also often lead to greater volatility in its share price.

Secondly, its share price will get dropped like a stone if the promised growth does not appear or even if its earnings are too volatile.

On the other hand, having a well communicated and reliable dividend policy and a history of paying regular dividends has a number of positive benefits.  Most notable include the rewarding and encouraging of long-term investing and the unique ability to help support the share price in tough market conditions.

The latter support of the share price is simply a function of logic.

Imagine that a company has a good track record of paying out dividends and the dividend has historically grown at 10% per year.  Assuming the latest Dividend per share (DPS) is 10c, an investor can expect forward DPS of 11c.

If the same investor could alternatively invest their capital into a risk-free bank account and earn 10% per year, then "risk-adjusting" this return to the stock's DPS implies that the share price will tend never to drop below 122c (=11c / (10% - 1% for a ‘risk-premium')).

If the share dropped below 122c, then investors would simply move their money from the bank account into the share to earn a higher return coupled with the potential for capital appreciation.  This flow of capital would move the share price upwards and lower its dividend yield until this yield agreed with the market norm.

Note that this example does ignore the effects of tax, brokerage and has some simplifying assumptions, like what exactly the ‘risk-premium' is. 

Despite these simplifications, the above example is evidenced by the fact that the dividend payers on AltX have collectively produced a one year return of 6% versus the AltX's index return of -55% for the same period (refer to the below table).

As can be seen by this, not only do dividends provide some price support of the share price, but the regular payment of dividend imply that the underlying earnings are both stable and cash generative. 

Declaring a dividend sends a signal to the market (especially if it is a small cap that is declaring the dividend) that management has confidence in future profitability and positive cash flows.

This positive signal concerning earnings prospects is especially true in the current economic environment that sees both cash flow and earnings pressure.  If a small cap is able to maintain (or grow or even declare a maiden dividend) in the current recession, then it bodes even better for future earnings potential.

While causality should not be confused (ie, a company that declares dividends might not necessarily be a successful one, but a successful company would probably declare dividends), it is a fact that the AltX dividend-paying shares have outperformed the AltX index benchmark over the last year. 

This simply fact does suggest that picking small caps based on their ability to sustainably pay dividends could improve your odds of investing into a diamond.

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