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.