From the Mailbag:

I love that Marc not only searches for strong yields, but also looks for stocks that have the potential to surge. Along those lines, what are your thoughts on small cap dividend payers? I’ve noticed a lot of small cap companies that pay dividends. Are these dangerous? Should they be avoided?

- Earl A.

Dear Earl,

Making a blanket statement like all small cap companies are dangerous is a lot like saying all Chihuahuas are ankle biters. Not only are you offending a lot of owners (and good dogs), but you also may be missing out on some tail-wagging investment opportunities.

Lots of small companies reward their shareholders with dividends. And sometimes, they make great investments. Sometimes.

No doubt, small cap stocks (those with a market cap of $1 billion or less) can be dangerous. So can large caps. But, much like my Chihuahua analogy, just because a stock is considered a small cap doesnt necessarily mean its a dangerous animal.

Some analysts will argue that a companys market cap is based on the value of its business. I dont entirely disagree. But a lot of market caps are based more on popularity contests than fundamentals.

Sometimes a low stock price or market cap is simply the result of a lack of investor interest. A lot of great companies fly under Wall Streets radar. Some of them are great businesses and possess attractive dividend yields.

The key to investing in small cap dividend stocks, or any stock for that matter, is to know what you are getting into. Evaluating the safety of the dividend is the same, and Marcs Safety Net criteria still apply. To determine whether the dividend of a small cap stock is safe, examine the companys payout ratio (based on free cash flow), cash flow growth and dividend history.

Small cap stocks get a bad rap for a variety of legitimate reasons. The one Im most concerned about is information especially a lack thereof.

If a small cap stock trades on a major exchange, the information is (or should be) available. Companies trading on the Bulletin Board are also required to file quarterly and annual earnings reports, called 10-Ks and 10-Qs, with the Securities and Exchange Commission (SEC). No problem.

However, if a company trades on the Pink Sheets, the company is not required to disclose its financials. Its the wild, Wild West of the stock market. Remember, without having access to the financial statements, the companys Ks and Qs, you cannot cross your ts and dot your is.

What I mean is that you cant determine the safety of the dividend or, for that matter, the viability of the business. I wouldnt take a Pink Sheet company CEOs word for it. Neither should you.

So now that you know small cap stocks arent all miniature Cujos, lets take a look at a real-life small cap dividend example.

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Black Box Corporation (Nasdaq: BBOX) is a small IT infrastructure company that has been paying dividends for over a decade. It currently sports a 1.8% dividend yield. With a market cap of $334.15 million, it definitely fits our definition of a small cap dividend payer.

Is the dividend safe? Lets find out.

First up, lets take a look at cash flow growth. Over the past year, Black Box grew its cash flow by 21%. Thats good. However, its three-year cash flow growth actually fell slightly, by 1%. So thats a dividend safety ding.

Next, lets review Black Boxs dividend history. The good news is that the company has not cut its dividend in over 10 years. That makes up for the small ding incurred above.

Finally, well examine the payout ratios. Last year, Black Box paid out over 11.39% of its free cash flow in dividends to investors. Thats a conservative ratio compared to Marcs 75% comfort limit.

So here is where analyzing the dividend safety of small cap stocks can get a little tricky. Most of the time, small cap stocks, like Black Box, have very little Wall Street analyst coverage. I dont usually care what the analysts have to say since they are almost always a day late and a dollar short.

But they do come in handy from time to time. Especially when trying to determine a forward payout ratio. Since there are no cash flow estimates for Black Box, Im going to have to go it alone.

Using the companys current cash flow growth rate, sales backlog and forward guidance, I can reasonably assume the payout ratio will be much lower than Marcs 75% limit.

It doesnt look like Black Boxs dividend will be taking a nosedive anytime soon. The Black Box dividend proves its not the size of the market cap that matters; its the cash flows that make a dividend safe.

Obviously, there are a number of other risks involved with investing in Black Box or any other small cap stock. Today I just analyzed the dividend safety.

Some other risks may include liquidity and shareholder concentration. Black Box doesnt trade much and investors may have difficulty buying or selling the stock. Also, if a major shareholder starts selling, the stock price will almost always move down more noticeably than a larger cap stock would.

So now you know. Dividend stocks, like dogs, come in all sizes. Even small ones can make great investments. Just make sure you arent barking up the wrong dividend tree.

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