The next dividend dazzlers

The hunt for yield will be a key preoccupation for investors over the next 12 months, but the game is changing from right under our feet.

While investors have been obsessed with stocks producing the fattest yields over the past year, I believe the focus will shift to “dividend growth” from “absolute dividend” in the coming months.

This means high-yielding stocks like Telstra and the big four banks are likely to play second fiddle to companies that are best placed to lift their dividend payments over the next few years as the latter group is primed to make further strong gains, particularly those at the smaller end of the market.

Growth investors (which include the majority of small cap investors) should stop sneering. This isn’t another story pandering to income chasers. If anything, growth investors should keep a keen eye out for companies lifting their dividends as dividend growth is a far more reliable indicator of a stock’s future performance than profit growth.

Eureka Report has compiled data from the 1,970 companies listed on the stock exchange and found that seven-in-10 companies that have lifted dividends consistently over the past three years have outperformed the All Ordinaries Index, with a stunning median return of 70.2% versus the 27.3% from the market benchmark.

What’s more interesting is that many of these companies did not fit into what many would consider “high-yielding stocks”.

Click to enlarge

In contrast, fewer than 40% of stocks that have generated consecutive earnings per share growth over the last three years have kept up with the gains on the broader market.

What’s more, it is a lot harder to find companies that can consistently lift dividend payments than those that can grow profits. Of the close to 2,000 listed companies on the ASX, fewer than 100 have lifted dividend payments every year since 2009-10, while 226 companies have generated consistent earnings growth over the period.

There are a few reasons for this. The fact that there are far more listed small companies that have yet to transition their businesses to a point where they are able to pay a dividend is one.

But the key reason, in my opinion, is because it is a much harder task to grow dividends than profits.

I am not saying growing profits is easy, but any decent small cap manager should be able to lift their profit from a relatively low base. On the other hand, paying a maiden dividend or increasing the payment is a lot riskier as managers are effectively issuing an implicit guarantee that they will at least maintain the payout, if not lift it, in the years to come.

Shareholders may be able to understand or forgive a miss in earnings during difficult times, but cutting dividends is seen as a cardinal sin. This is why managers deliberate at length before changing the company’s dividend policy, and they will only do it if they have confidence in their future.

This doesn’t mean managers will not artificially bolster their dividend to give their stock a temporary shot in the arm, but such cases are rare due to the risk of losing credibility in the market. This is why it is far more common to see companies massaging their profit numbers instead.

I believe most company boards are actively examining ways to increase dividends this August, particularly if they worry that their earnings will disappoint, because lifting dividends is the cheapest, if not easiest, way to support their share prices.

However, I am not expecting a wave of companies to lift dividends when they hand in their earnings report cards this month. What I do believe though is that companies with the ability to pay higher dividends will probably do so unless they are planning to make acquisitions – and I don’t think many will launch takeovers given the lack of confidence and risks involved.

Those that have already gone down this route have been rewarded. Packaging company Colorpak (CKL) rallied to a fresh record high of 85 cents when it raised its dividend by 7.7% to 3.5 cents, while debt purchase and collection agency Credit Corp Group (CCP) jumped over 1% to $9.60 in two days when it increased its payout by 28% to 37 cents a share. Both stocks are in the Uncapped 100.

I believe that companies well placed to deliver dividend growth are likely to enjoy a price-earnings (P/E) expansion, which means the market is willing to chase such stocks even if their P/Es are moving into what is considered “expensive territory”.

Over in large cap land, Resmed is a notable example. The stock surged to a record high of $5.45 on Friday thanks in part to its decision to pay a record quarterly dividend of US25 cents, up from US17 cents a share.

There is also an air of expectation around mining giants BHP Billiton (BHP) and Rio Tinto (RIO). Their cut back on capital expenditure in the face of volatile commodity prices means that they have the ability to increase dividends. If they don’t, things are likely to get ugly.

I think there is a similar expectation that is priced into the share price of Commonwealth Bank of Australia (CBA).

The only question left for small cap investors is how to pick the dividend dazzlers. Interestingly, consensus forecast is predicting that close to 40% of emerging companies on the Uncapped 100 will increase their dividend this month.

However, if I screened the stocks to find those in the strongest position to keep growing their dividends, the list would drop by more than half.

The stocks that are left are highlighted in the table below. These companies have a low payout ratio (the amount of dividends paid compared with profits booked) of 70% or less, are forecast to grow profits this year, and generate more cash than required to run their business and pay dividends.

Click to enlarge

While the list won’t bring much joy to the value investor as the stocks have all rallied sharply over the past year, a few of these stocks could be re-rating (P/E expansion) candidates.

Collins Foods (CKF) is one possible candidate, although just about all brokers covering the stock are rating it a “hold” as it is trading on a 2013-14 P/E of a little over nine times – which is in line with its five-year average.

The restaurant operator is struggling to turn around its struggling Sizzler restaurants, which account for around a quarter of total sales, with the balance coming from its Kentucky Fried Chicken fast food chain.

If management can convince investors that Sizzler is turning a corner in the current financial, it could justify a re-rating to around 12 to 14 times. This implies at least a 33% uplift to its share price, and even then, the stock would still be trading at a discount to its peers.

I recommend investors buy the stock in anticipation of the re-rating as its balance sheet can sustain further increases to dividends over the next three years, with analysts expecting dividends to rise to 12c a share by 2015-16 from 9.5c a share currently. The company’s financial year ends in April and it will release its half-year result on November 28.

Another Uncapped 100 stock that has the financial muscle to keep ramping up dividends over the next few years is engineering contractor LogiCamms.

The company is tipped to increase its full-year dividend by 1 cent to 9.5 cents for 2012-13 and that would put the stock on a gross-up yield of around 9%.

While LogiCamms is not immune to the slowdown in project spending, the recent acquisition of Independent Technology Holdings and its diversified customer base across mining, oil and gas, and infrastructure has given the company enough confidence to forecast “solid earnings growth” for 2012-13.

Even if LogiCamms’ earnings come in flat, its balance sheet is strong enough to support an increase in dividends given that the business is highly cash flow generative and its payout ratio is a modest 54%.

Think big, go smalls!

Brendon Lau does not hold shares in CKF or LCM.