Catch a rising star.

• Author: Schwarzkopf, Robert
• Position: Rising dividends method - Risk Management

Like small-cap stocks, dislike the risks? A strategy called the rising dividends method may help you pick some winners and still sleep at night.

For many institutional investors, choosing to invest in small-cap stocks has always been a tough call, especially in the risk department. On the positive side, the stocks' history of outperforming the Standard & Poor's 500 index is well-documented. According to Ibbotson Associates, during the 20-year period from 1974 to 1994, the real returns of the S&P 500 about tripled, while small-company stocks generated a tenfold increase (including reinvested dividends). On the other hand, small stocks have always been more risky in terms of market volatility. And they're at their most precarious during the worst of times, in declining markets.

While investors are tantalized by statistics that show the majority of the top performers during each of the past two decades have been smaller stocks, the inverse relationship between capitalization and stock volatility is a significant deterrent. As for financial executives, the sentiment of some is that while the potential for high returns is enticing, they haven't the stomach for gambling on the loss of a good portion of their companies' investment assets.

But volatility isn't pervasive among all small stocks. A few produce consistently high returns without displaying characteristic small stock instability. By using certain criteria, you can target these stocks and thus mitigate the risk of investing in small caps. Let's examine some of the characteristics of successful small stocks.

Tootsie Roll Industries is an uncommon small-cap stock that has produced a decade of consistent growth in sales, earnings and dividends off an entirely unleveraged balance sheet. The firm has manufactured candy since 1896 and has strong brand franchises, including Tootsie Roll, Tootsie Roll Pops and Sugar Daddy, as well as acquired brands Charms, Mason Dots and Junior Mints, all of which help it dominate a unique market niche.

The company's strong earnings belie the fact that cash is one of the largest assets on its balance sheet. Despite strong sales growth averaging 14 percent during the past three decades, Tootsie Roll generates excess cash flow continuously, contributing to its long-term growth record and its strategy of acquiring other healthy candy brands. And the business isn't capital intensive. Every dollar of plant and equipment generates over three-and-a-half dollars of sales. The company uses its strengths in distribution to broaden its businesses and reduce operating costs.

SOLID AS A ROCK

Bank of Granite is another good example of a stable small stock. Founded in 1906 and headquartered in Granite Falls, N.C., independent Bank of Granite is ranked as the number-one bank in the nation, according to U.S. Banker magazine, with a 2.6 percent return on assets. With 16 percent equity-to-assets, Bank of Granite is one of the nation's strongest banks, and it's seen 42 years of consecutive dividend increases. It also has an efficiency ratio (non-interest expense as a percentage of non-interest income...