When The Investor asked me to continue my series on dividend investing, I decided it was time to step out from behind my moniker. The name’s Todd Wenning, aka The Analyst, nice to meet you. Please see the bottom of this post for full details. As a regular Monevator reader who enjoys the community here, it’s a pleasure to be back with you talking dividends!
Today I’d like to explore dividend-paying smaller companies, also known as small cap shares.
Look through most dividend-focused portfolios, and you’ll find them heavily weighted toward blue-chip stocks. There’s nothing wrong with that, and FTSE 100 companies can serve as a solid anchor in a dividend portfolio.
That said, large companies tend to be the most covered companies by the City, and there are thus limited opportunities to outfox other investors.
Small cap dividend shares, on the other hand, often fly under the City’s and other investors’ dividend screens. I believe this makes them attractive candidates for those of us doing our own fundamental research.
Further, even if large investors wanted to invest in small caps, they frequently run into the problem of not being able to buy enough of the business to make a difference in their portfolios.
As individual investors, we can take more significant stakes in small companies.
Not for everyone
Naturally, small caps aren’t without their risks.
Relative to large caps, small caps tend to be less diversified, have a harder time accessing capital in recessions, and their executives may jump ship when offered a bigger paycheck at a larger company.
Not to mention their share prices are usually much more volatile. Daily moves of 5% or more in either direction are not uncommon.
As such, wading into the small cap pool requires patience, a business focus, and a stoic mentality.
So when evaluating small-cap dividend-paying stocks, I get interested when I see one or more of the following attributes.
1. Low debt or preferably no debt
A few years ago I was speaking with the tenured CFO of a small cap firm in the U.S. His company had a net cash balance sheet (i.e. they had more cash than debt) and I asked him if he was under pressure to increase the company’s borrowings.
He replied that whilst investors were urging him to borrow now (in a good market), those voices were silenced during the financial crisis a few years earlier.
Debt’s siren song can be enticing for small enterprises wanting to get big quickly. Too often they forget that leverage cuts both ways. If the economy, industry, or company faces a downturn, that extra leverage only exacerbates the problem and puts the company at risk.
As Warren Buffett put it in his 1987 letter to Berkshire Hathaway shareholders: “Really good businesses usually don’t need to borrow.”
All else equal, it’s a positive sign when a company can grow using internally generated cash.
2. An invested leadership team
If I’m going to invest in a smaller company, I want to see that my interests and management’s are aligned to the greatest extent possible.
One way to check this is to evaluate management’s incentives.
When reading the remuneration report, ask yourself, “Upon which metrics are management’s bonuses based?” and “Will those metrics encourage the right behaviour?”
I also like to see that management and the board together own at least 5% of the outstanding shares. By having skin in the game, they are less likely to take undue risks or pursue growth-at-any-cost acquisitions that might jeopardize the dividend.
3. Steady free cash flow generation
Since dividends are paid from free cash flow (i.e. the money left over after the company reinvested in the business), it’s a positive sign when the company has displayed an ability to generate free cash in various markets.
A pure commodity company, for instance, may have bumper free cash flow during booms, only to burn through cash in the troughs
Volatile cash flows are a less-than-ideal scenario for dividend investors. Instead, focus your attention on firms that can deliver cash flow in both good and bad markets.
Steady free cash flow generation across the business cycle can also serve to build the board’s confidence in the business’s long-term prospects, leading to dividend increases every year.
4. Dominant in a profitable – ideally boring – market niche
What’s the firm’s Total Addressable Market (TAM)?
If the company is growing rapidly in a large TAM (say, social media) it will surely attract competition from larger firms with robust resources.
On the other hand, a large company will likely either acquire a small company that’s dominating an attractive-but-limited TAM, or else leave it alone.
If the small company operates in a decidedly dull industry – think industrial parts, safety equipment, waste management – then that’s even better. These industries are less likely to attract new participants. This helps the small company maintain profit margins and free cash flow production to support the dividend.
5. A payout ratio below 50%
Companies, large or small, that pay out much more than 50% of their free cash flow are likely in mature or declining industries. These types of companies can boast high yields make for good investments at the right price, but if dividend growth is important to you, focus instead on companies with ample cash flow after dividends.
If you trust the management team and there are good reinvestment opportunities, management can plow the extra cash back into the business to accelerate growth.
Given the relative lack of City coverage, investing in small-cap dividend-paying shares takes some extra research on your part. Yet because they aren’t often included in popular dividend-themed ETFs or mutual funds, I believe the return on your research time can be higher than if you focused solely on blue chips.
Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.
@Everyone — Morning! Please remember our recently clarified comment policy. Relevant comments for this post would be tips for hunting for small cap dividend stocks, the historical returns from a small cap income strategy, pros and cons of small cap income versus large cap income, why you might prefer larger cap income shares to small cap shares, and so on. A preference for tracker funds or distaste for dividends, say, are NOT on-topic here. We have had (and will have) other posts where those debates can be had in the future. Cheers! 🙂
I’ve been using an Investment Trust as a vehicle to invest in this area, Chelverton Small Companies Dividend Trust (SDV). It’s produced a nice income and capital growth over the years. IMHO, a look through their portfolio brings up some good candidates for further research.
One factor that makes me wary of small-caps is the lack of governance on AIM. It’s not just the ever-growing list of false accounting scams (many, but not all, Chinese) but also the conflicted role of the Nomad, which is supposed to both promote the firm and police it.
Recently, for instance, a small-cap in which I’d invested, Entu, announced the sale of a division that contributed £1.1m in EBITDA – for a Pound. Oh, less fees. Apparently to an unconnected party. Suspicious? You might think so, but despite me raising it with both the Nomad and AIM Regulation four months ago, to date nothing has been done.
For this reason I prefer investing in small-caps via investment trusts, because I figure that their status as serial purchasers of equity in AIM firms gives them the ability to punish Nomads who push dodgy firms by disbelieving them and hence shunning their clients in the future. In terms of game theory, it turns what would, for a private investor, be a single period game in which the incentives favour the cheating firm and Nomad to a multi-period one in which the investor can retaliate, deterring first-period dishonesty.
@Mark — I find it quite possible to avoid AIM wrecks, to be honest, it’s many years since I suffered a really bad result due to governance issues. (And when I did, I lost everything — my worst ever wipeout — so I certainly acknowledge the danger!)
A very good first pass heuristic is “are people discussing this share a lot on ADVFN”. Seriously. If the answer is yes and it’s not one of a handful of AIM companies I’d automatically give the benefit of the doubt to, then I avoid.
But otherwise there are gems on AIM that I’d trust above many main market companies.
Also, AIM is not synonmous with “small cap”. There are plenty of small caps on the main market. (In fact about half the All-Share would be considered small cap by US investors! 🙂 We’re really talking microcap with those AIM tiddlers etc).
All that said I wouldn’t argue a jot with the small cap investment trust route. Most non-investing fanatics will find them plenty risky and rewarding enough.
@ The Investor, I take your point re certain bulletin boards. And I find Tom Winnifrith, the self-appointed Sheriff of AIM, tends to spot some of the real villains pretty early on. But I think it’s unfortunate that we can’t trust such basics as published financial reports and RNS announcements in AIM.
And of course I take your point that not all small-caps are on AIM (depending on your definition of ‘small’). Some of my most successful direct investments have been dividend-paying, cash-generating growth stocks from the FTSE250 or all-share index, but not AIM. You get the benefits of half-decent corporate governance but often at a lower PEG ratio than bigger companies with similar fundamentals.
I enjoyed this post. Although most of my portfolio is invested in index trackers, ETFs and investment trusts, I indulge a suppressed active investor within me by ring fencing a small proportion of the portfolio to investing in small cap dividend shares. I suppose the interest in dividends reflects the fact that I have recently retired and ultimately plan to boost my income with these holdings. Overall I’m quite happy with the performance of this sub-portfolio and enjoy investing in companies that are perhaps more human in scale. I realise that the real test of my happiness in my strategy will be the end of the current bull market and the way it performs under even more market uncertainty!
I very much agree with the Analyst’s criteria for picking stocks: a strong balance sheet is critical, together with a reasonable valuation and prospect for sustained dividends and growth. A few additional points:
1. For UK investors, be aware of the current uncertainty around the effect of Brexit: with a weak pound having a strong export market is a major plus for a small company, particularly if it is not importing a lot of raw materials.
2. Because small caps tend to be volatile, try to diversify across market sectors.
3. Be aware that very small caps can be illiquid (i.e. because there is a small market for them buying and selling can be difficult). This means you may be faced with a low price if you need to sell in a hurry (and vice versa) – particularly if you want to deal a lot of shares.
4. There are some good small cap information sources on the internet – I came across Paul Scott through his blog on Stockopedia, but his own site at http://qualitysmallcaps.co.uk/about/ is generally accessible and has a lot of interviews with smaller company management. V. interesting.
I hope I won’t fall foul of the new guidelines here, but I wonder if VCTs would be relevant here. Again one has to feel comfortable with the potential risks, and the fees would cause Passive types to blanche, but it has been possible to get an impressive dividend stream from the best ones.
That said, I am not an expert on the recent VCT changes, but get the sense that it means they will have a greater focus on earlier-stage companies in future, meaning that the dividend streams may not be so good in future (though the older VCTs may be able to do it for a while).
I don’t think I can outfox ’em, I might be able to out bore them tho!
When/if I retire I think spending time analysing the small caps might turn out to be a fun hobby. I do love dividends, nothing quite like collecting money that would have shown up even of you hadn’t bothered to get out of bed.