Three small cap dividend dazzlers

You would be forgiven for thinking that small cap stocks have no place in an income portfolio as their unsavoury reputation for being volatile makes them better suited for risk tolerant growth-seeking investors.

You’d be forgiven, but you’d be wrong.

In fact, your income portfolio would probably have suffered if you had excluded small cap stocks.

Stocks with a market capitalisation of under $800 million, yields of at least 5% and a positive five-year compound annual growth rate for dividends have produced an average total return of 8.8% over the past five years.

Using the same yield and dividend growth filters on the top 100 stocks would have given you a total average return of 7.7% over the same period.

We are likely to see this trend continue over the next five years for two reasons. The forecast 2013-14 dividend for stocks at the smaller end of the market is 0.4 of a percentage point higher than high yielders on the S&P/ASX 100 Index.

This, coupled with the fact that dividends are likely to make up a bigger proportion of total returns given the lacklustre profit growth environment, means that stocks with a high and sustainable dividend yield are in a better position to outperform the broader market in the coming years.

But returns aren’t the only reason for income-seeking investors to consider small cap stocks.  There is a risk advantage too.

The problem with building an income portfolio from large caps is that it will lead to “concentration risk” given the shallow pool of high-yielding stocks.

A large cap high-yielding portfolio will automatically lead to an overweighting towards the banks and telecom giant Telstra.

Concentration risk is the key reason for the unsettling surge in popularity of hybrids, even though many retail investors do not properly understand the differences in risks between hybrids and common stocks.

This is why those willing to consider smaller stocks as a supplement to their large cap holdings will have a better diversified portfolio.

Those trying to work around this diversification problem may have been driven to high-yielding exchange-traded funds (ETFs).  But these ETFs either totally ignore small cap stocks or have very limited exposure to the sector.

This isn’t so much to do with questions over the quality of smaller companies, but liquidity.  Small stocks are a headache for large funds because of the difficulty in getting a meaningful position in the stock.

Exiting is just as stressful as it would likely spark a large unfavourable movement in the share price.  

Luckily for retail investors, liquidity is not as big an issue due to the relative modest size of their portfolio. 

Nimble investors should use this to their advantage, and the trick here is finding tiddlers that are well placed to not only sustain their dividend payout, but to grow them over the next few years.

There are three small cap stocks that are worth highlighting, although one should bear in mind the following points before reading further.

The first is that this isn’t a valuation call.  If anything, these stocks have performed well and some might say they are now fairly valued on a one-year forward price-earnings basis.

This means the stocks could fall in the short term as they swing around the so-called “fair value” line.  But share price movement aside, the most important consideration for income investors aside from yield, is the quality of their dividend stream.

If the company can keep growing dividends year after year, the valuation issue will sort itself out.

The second point is that the three stocks listed below are not the only quality stocks with a generous dividend.  In fact, they are not even the highest yielding among small caps that are expected to lift their distributions over the next few years.

Choosing income stocks is often a trade-off between earnings growth (which is typically linked to dividend growth) and earnings volatility, and the three below seem to strike a good balance.

More importantly, these stocks are tipped to generate a yield that is well in excess of the “consumer price index (CPI) plus four” target that many large asset managers are aiming for over the next year. This equates to the inflation rate, plus 4%. If the CPI comes in at around 2.5%, these fund managers will be hoping to make 6.5%.

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Mortgage Choice (MOC)

The mortgage broker should quite easily beat this benchmark given that it has a grossed-up yield of over 9% (grossed-up yield includes franking credits).

The $250 million market cap company is too small for the large funds but just the right size for retail investors.

The only disappointing thing about Mortgage Choice is management’s guidance last month that its 2012-13 dividend payout will be flat on the previous year.

It’s understandable why management has taken the cautious stand on distribution given that Mortgage Choice is impacted by the sluggish housing credit market and is stepping up efforts to steal market share.

But the company still managed to record a 17% jump in net profit to $7.5 million and a 3.3% increase in revenue to $74.2 million for the six months to end December.

Further, if the housing market picks up later this year, as the recent housing data series seems to be indicating, the company should be in a strong position to keep growing its dividend.

The stock isn’t cheap though as it is trading close to last week’s four-year high of $2.08, but companies with relatively resilient business models and a track record of generating a return on equity of between 20% and 30% seldom are.

Ardent Leisure Group (AAD)

The entertainment and fitness facilities operator is another with characteristics that will appeal to conservative income investors.

Ardent Leisure, which has a market cap of over $500 million, is expected to yield around 8% and has proven itself to be fairly well insulated from the wild swings in consumer spending.

That’s thanks to its diversified business, which spans across theme parks to bowling alleys and fitness clubs.

A downturn in one part of the business has been generally offset by growth in another – and this was proven several times in the past few years, which has seen the global financial crisis, devastating floods and cyclones in Queensland (where it’s theme parks are located), and the general pull-back in discretionary spending.

While not many brokers will be encouraging investors to buy the stock after it has run up 130% over the past year, the stock will look enticing to dividend hungry investors over a two- to three- year time frame as Ardent is forecast to grow its dividend by close to 10% a year for the next three years.

Thorn Group (TGA)

The owner of the Radio Rental chain has the lowest yield of the three but it has arguably the most battle-tested business model.

Still, it’s grossed-up yield of around 7.5% for 2012-13 is nothing to sneeze at, particularly if you consider that the company’s dividend has grown 21% a year on a compound basis over the past five years.

Only two other industrial small cap companies have achieved stronger dividend growth, and Thorn Group’s dividend increase should come as no surprise as it has delivered top- and bottom-line growth every year since 2008.

Not even the global financial crisis could slow it down.  If anything, the crisis may have actually helped Thorn’s core “rent-try-buy” business by driving more consumers to rent household appliances and computers instead of buying.

Thorn is one retail-related company that can do reasonably well in just about any economic cycle, and it has room to grow dividends given its conservative payout ratio (the proportion of profits it pays out as dividends) of around 50% and strong operating cash flow.

Brokers polled on Bloomberg are expecting the group to increase its dividend for the next two years at least, which would put Thorn on a grossed-up yield of close to 9% on their 2014-15 forecasts.

Brendon Lau is the small caps writer for Eureka Report and may have interests in some of the stocks mentioned in the article.