Catch a rising star.

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, plus net interest income after the loan loss provision) of 35.7 percent, vs. an industry average of 64.8 percent.

And then there's Liqui-Box Corp., a major supplier of flexible bag-in-a-box packaging and filling equipment to the beverage, bottled water, dairy, specialty chemical and wine industries. Its customers include Wendy's, Carnation, Borden, Heinz, Coca-Cola, Pepsi and others.

During the past decade, dividends and earnings have grown at 18 percent and 20 percent, respectively. Every dollar invested in plants and equipment generates more than $5 in sales. Free cash flow after capital expenditures, working capital requirements and shareholder dividends amounts to more than 15 percent of net worth. Historically, the company has used this free cash flow to make small acquisitions in related businesses. For example, it recently purchased a small European packaging company, which will help it gain a foothold in the European market. The company also uses excess cash flow to repurchase Liqui-Box common stock in the open market.

Management strives to make the best use of cash. The chairman has a philosophy of returning cash to company shareholders. Executive compensation is tied to profitability, and the company's headquarters aren't lavish. Everyone flies coach and stays at budget hotels.

How can you uncover small-cap gems like these? Certainly not through Wall Street, which does little research on small-cap stocks. Despite Tootsie Roll Industries' name recognition and financial success, Bank of Granite's ongoing rating as the nation's most profitable bank, and Liqui-Box's recent penetration of international markets, no Wall Street brokerage firm has ever issued a financial research report on any of these companies they're just too small.

Tootsie Roll Industries, Bank of Granite, and Liqui-Box Corp., along with an elite group of other small stocks with rising dividends like American Heritage Life, Brandon Systems, Cintas Corp., Cooper Tire & Rubber Co., Premier Industrial and Roto Rooter, represent a very small segment of the small- to mid-cap market in the United States - about 2.5 percent. Ferreting out these stocks requires a disciplined, low-risk approach that can focus on and isolate well-managed companies. Characteristics of the stocks that meet these parameters are low debt, reinvested earnings and rising dividends. Separate research confirms that these stocks also tend to emulate gains in rising markets, while losing less when markets decline. That's because their ability to consistently raise dividends often means they aren't hit as hard by market cycles.

ROOT FOR THE UNDERDOG

These studies became the genesis of an investment strategy called rising dividends. Fundamentally, the strategy seeks to create a portfolio that matches the investment returns of small stocks, as measured by the Russell 2500 Index, while assuming less risk. The philosophy is grounded in the belief that you can significantly reduce the risk of investing in small stocks by selecting companies able to generate a steadily growing cash flow for dividend payment from an under-leveraged balance sheet. A strong balance sheet is the underpinning for stability, and paying consistently rising dividends indicates a company able to finance its own growth.

The rising dividends philosophy is a risk-averse equity approach. Essentially, the idea is to uncover financially sound, growing companies by applying a series of screens to the universe of some 7,500 small- to mid-cap stocks (those with stock market capitalization of less than $2 billion). The investment criteria include an increased dividend in at least three of the last five years or seven of the last 10 years, increases that project to a doubling of dividends in 10 years, at least 35 percent of earnings reinvested in the business and long-term debt that's less than 35 percent of capital.

Applying these screens reduces the universe of 7,500 stocks to an elite group of about 200 companies. Once you identify the companies that meet the initial rising dividends screens, you can conduct a research and pricing evaluation, dissecting each company and developing a historical spreadsheet analysis of its financials, including income and cash flow statements, balance sheets and stock valuation.

While this kind of extensive, independent research is important in selecting large-cap stocks, it's absolutely critical in selecting small- to mid-cap issues, especially in light of the lack of Wall Street research. Real conviction in choosing small-cap stocks can come only from comprehensive internal research. In general, you should allow a full day to research each company. And you need to do that at least four times a year to stay current.

Next, you'll need to evaluate upside potential, risk/reward ratio, and whether the stock is attractive within its particular industry. You can make projections for each company's growth in dividends, earnings, cash flow and book value to arrive at a value range - that is, a trading range the stock is expected to fall within during the ensuing 12 to 18 months.

For example, going back over the previous 10 years, you can examine each company's highest yield, lowest price-earnings multiple, lowest price-to-book and lowest price-to-cash-flow each time the stock hit the bottom of the market. Then combine these numbers in conjunction with the upcoming years' estimates for the firm to arrive at the downside risk price. You should conduct the same historical examination for the ratios at the high side of the market, which ultimately yields what the upside stock price should be in the coming year.

Together, the two form a value range. Based on the stock's current price, you should seek a minimum of a 3-to-1 upside potential. So, for example, if the established price range is 25 to 50 for a stock currently selling at 30, the downside risk is five, with an upside potential of 20, equalling a 4-to-1 upside ratio.

LOOK TWICE BEFORE CROSSING

Often, rising dividends research will uncover a stock in an industry that has lost favor with Wall Street. In turning its collective back on an industry, Wall Street takes a broad-based approach instead of looking at individual companies within the industry. Obviously, some companies within that group will have less risk than the industry as a whole. These are the opportunities that rising dividends screens seek to uncover.

For example, when real estate prices plummeted, most bank stocks suffered. But the rising dividends approach unveiled some bank stocks that did exceptionally well. These turned out to be banks that didn't do a great deal of real estate lending, such as River Forest Bancorp, which established itself as one of the largest lenders of student loans. Another discovery was National Commerce Bancorp, which originated the concept of supermarket banking.

Writing in Worth magazine, Peter Lynch cites four small bank stocks that made the list of the 100 best-performing stocks overall during 1983 to 1993, a highly volatile decade for bank stocks during which investors lost huge sums from bank failures and the savings and loan debacle. The successful banks are River Forest Bancorp and Trustco Bancorp of New York, Tompkins Country Trust Co. of Ithaca, N.Y., and National Commerce Bancorp of Tennessee. All these stocks meet the rising dividends criteria.

Lynch also wrote, "If it's a choice between investing in a good company in a great industry, or a great company in a lousy industry, I'll take the great company in the lousy industry any day." He notes that among the 100 best-performing stocks of the 1973 to 1983 decade were several industrial cyclicals: a paper company (Wausau), a lone steel company (Worthington), a small oil company (Holly) and a single tire maker (Cooper). Three of these four stocks meet the rising dividends criteria.

Some institutional and corporate stock investors take the approach that if they're going to invest in small-cap issues, they want to go where the potential returns are greatest. Typically, this means high-tech stocks. But high-tech is also the riskiest sector of the small-cap universe. Perhaps high-tech should be subtitled high excitement. A preferable approach for financial executives is to match high incremental return with high-quality issues, and the rising dividends philosophy can play a major role in achieving this objective.

Small stocks have greater potential for return because small companies can often grow faster than large companies; they're less bureaucratic and can move more quickly to exploit emerging market niches, even though downsizing and re-engineering has narrowed the gap by enabling large companies to be far more nimble than in the past. During the past decade, small- to mid-cap companies have provided the lion's share of economic growth in the United States. Historically, cash dividends and their reinvestment have accounted for almost half of the returns in the equity market. Even during steep market drops, dividends have continued as an integral portion of equity returns, and as a benchmark that helps identify companies best able to withstand downturns.

THERE'S GOLD IN THOSE HILLS

Plus, since Wall Street tends to ignore small- to mid-cap stocks, it creates an inefficient market and therefore a conducive environment for unearthing underpriced issues. This offers a good opportunity for investors able to perform their own research.

One of the greatest challenges for smaller companies is generating sufficient capital to fuel their growth. Rising dividends are a clear indication of stability, profits and a company's ability to finance itself. While small stocks are more risky than large-cap stocks, those meeting the rising dividends screens minimize that risk.

Of course, the rising dividends method isn't foolproof. For example, there are some good companies that don't issue dividends at all, so this methodology wouldn't reveal their strengths. And you do run a major risk of not being able to invest in a new growth area. For example, if you adhered solely to the rising dividends criteria to pick small caps last year, you wouldn't have been able to invest in any of 1995's wildly successful initial public offerings of Internet-related businesses, because none of those businesses have a five-year history. You'd have to wait to see how the businesses hold up on the other side of an economic cycle.

But overall, the rising dividends philosophy is a disciplined, low-risk approach that can help you identify the stable companies in a generally volatile market sector. It's an investment philosophy tailored to financial executives and corporate investment managers who want to access the growth potential of small- to mid-cap stocks while minimizing risk. While using it doesn't guarantee you'll pick a winner every time, you might find you're in for some pleasant surprises.

RELATED ARTICLE: SMALL BUT MIGHTY

The chart below, which compares the performance of a typical rising dividends portfolio to the Russell 2500, demonstrates just how well small stocks whose dividends are rising have done. As the numbers show, when you compare earnings-per-share [TABULAR DATA OMITTED] and dividend-per-share growth, as well as average return on equity, the performance of the rising dividends portfolio is impressive. But just as important, the beta or risk factor is meaningfully less than the Russell 2500 beta.

Mr. Schwarzkopf, CFA, is vice president of Kayne Anderson Investment Management in Los Angeles, and he's also a portfolio manager and financial analyst in the firm's private accounts division. He can be reached at [phone].