Small-cap dividend champions (and how to find them)

Jack Collopy, Perpetual Investments

It’s very easy to fall into the trap of just screening for stocks with high dividend yields. 

However, what matters more is the sustainability of the earnings that support those dividends.

Before even thinking about the yield on offer, we want to get comfortable that a company will be able to sustain – and ideally grow – its earnings over time, without taking on an unnecessary level of debt.

We are very strict when it comes to assessing the quality of a company’s balance sheet as well as the recurring nature of its earnings.

If we were to run a screen for quality income-producing stocks, we’d start by looking for companies with

• Conservative gearing,

• A track record of steady profitability and

• A dividend policy which doesn’t constrain management’s ability to reinvest in the business.

Some names which tick these boxes for us include:

We look for quality companies with:

1. A competitive advantage,

2. A history of consistent, recurring earnings,

3. Capable management,

4. The ability to grow earnings and

5. All at a reasonable price.
   

Yield has always been an important component of returns in the small-cap sector. While a company’s ability to grow is desirable, companies that can pay a sustainable, consistent and growing yield over time should be a consideration in every portfolio.

Our focus on quality and value culls many stocks from the list, leaving a list of what we believe to be potentially superior investment opportunities. Dividend streams and supporting cash flows are, then, a key factor in our portfolio construction.

Here are some of the top 10 small-cap income stocks, in order of yield, that have passed our screening process and successfully made it into IML small-company portfolios:

• Interest cover >5x

• Payout ratio <80%

• Net debt/EBITA <3x

You can see the results of the screen in the spreadsheet on the spreadsheet which is available here. To help orientate you, the column on the far right showing ‘Total meets’ shows the number of times that one of the three conditions above has been met. In the three columns to the left of that, you can see which of these conditions have been met. 

Having screened to create a shortlist I then qualitatively assess each company on:

• the quality of business which feeds into the sustainability of the dividend.

• the strength of the management team including what I know of their capital management framework and track record.

Dividend traps and top picks

If you enjoyed the responses from Jack, Marc and Matt above, watch out for the next two wires in which they discuss the big risks to consider when investing in small-cap income stocks, and their nomination for their top pick in this space. Hit FOLLOW to get it first.