It seems that dividends have become passe. Now all the talk is about stock buybacks. However Todd Wenning at Clear Eyes Investing has some different thoughts that he has captured in his new book: Keeping Your Dividend Edge: Strategies for Growing & Protecting Your Dividends.
There are no shortage of dividend-focused ETFs that investors could choose from. However Wenning argues that investing in individual dividend stocks is particularly well-suited for individual investors. This is due in part because it forces you to be patient and to think long-term.
The following is an excerpt from Chapter 7 of Wenning’s new book Keeping Your Dividend Edge: Strategies for Growing & Protecting Your Dividends. Copyright (c) 2016 by The W8 Group, LLC.
Traditional dividend analysis typically focuses on larger stocks due to their perceived safety (i.e. more financial resources and lower chance of going bust) and steers clear of small caps for the opposite reasons. On the contrary, there are plenty of smaller firms with good competitive positions, solid balance sheets, impressive management teams, and a distinguished dividend track record that I would consider just as steady as blue chip firms. Moreover, they may be more nimble in reacting to rapidly-changing markets compared with large caps, which tend to alter their course with the agility of an ocean liner.
A classic example of a quality small-cap is U.K.-based electrical equipment company, FW Thorpe, which has increased its payout each year since 2002 (including periodic special dividends) and has traditionally kept a clean, debt-free balance sheet. Further, as of this writing, descendants of the founder continue to own over 40% of the company, which I believe gives the company a relatively rare ability in the public markets to think longer-term and suffer through short-term hiccups.
The small cap universe is much broader than the well picked-over large cap space. Certain small caps may also have longer growth runways than their larger peers. As such, they shouldn’t be overlooked.
When evaluating small cap dividend-paying stocks, I look for the following attributes:
- Low debt or preferably no debt. Diversified, larger firms can get away with having more financial leverage and can typically get better rates on their borrowings, whereas smaller companies tend to be more cyclical or more reliant on one product line, so a rock-solid balance sheet is a must-have for a smaller company that pays a dividend.
- An invested leadership team. With small caps, I like to see insiders own at least 5% of the company. Having some skin in the game should motivate management to allocate capital with a long-term ownership perspective in mind.
- Steady free cash flow generation. This is always necessary when evaluating dividend-paying stocks as dividends must ultimately be funded by free cash flow in order to be sustainable. It’s a particularly good sign when a small company is able to generate free cash flow across the business cycle.
- Dominant in a profitable market niche. Small companies with dominant shares of niche markets may be less likely to attract the attention of large competitors. That’s because the niche could be too small to make a difference for the large competitors. If the niche is attractive enough, the larger companies are more likely to simply acquire the dominant player instead of entering the market themselves.
- Operates in a decidedly boring industry. I like to see a small company operating in an industry that’s unlikely to attract investor attention – e.g. industrial parts, safety equipment, and food processing equipment. The longer the business can fly under investors’ radars and not be of interest to potential competitors, the better.
- A payout ratio below 50%. Small companies with a long growth runway should be reinvesting at least half their cash back into the business to fuel long-term dividend growth. A firm that is paying out much more than 50% of its earnings is likely in the mature or declining stage of its lifecycle.
Researching smaller cap dividend-paying stocks requires a bit more legwork than researching large caps where information and analysis is more plentiful. If you’re looking for firms with strong capital return potential, however, it can be a good place for dividend-minded individual investors to spend their researching time.
Disclaimer: Todd Wenning, CFA is an equity analyst and writer based in Cincinnati, Ohio. Opinions expressed here and in his book are his own and not those of his employer.
The following excerpt was from Keeping Your Dividend Edge: Strategies for Growing & Protecting Your Dividend. You can find it at bookstores everywhere including Amazon.