Stocking gifts are not the only good things that come in small packages. Small-cap stocks can offer investors market-beating growth and still provide a regular dividend stream. Look for companies with strong sales growth, a return on assets above 10% and a positive history of increasing cash returns.
Can small companies be good dividend plays?
You don’t normally hear small-cap and dividends in the same sentence but the total return on these stocks can be more than enough to compensate for the higher risk. You do need to be a little more watchful to changes in the company’s business model and there are a few criteria that are a must for inclusion.
Even though most definitions for small-cap include companies between $250 million and $1 billion, I like to focus on companies of at least $500 million and up to $1.5 billion. This helps to avoid those that continuously need to raise funds yet still gives them the flexibility of a small grower. Besides market cap, I use fundamental analysis to screen for financially healthy companies.
Beyond all the ratios and cash flow analysis, sales growth is one of the most simple and important metrics. Annual sales do not have to be higher every year but a general upward trend is definitely a must.
Most investors look to Return on Equity (ROE) as their preferred profits metric but I like Return on Assets (ROA) because it removes the effect of leverage. I want to make sure that management can make money off of its resources without having to take on a dangerously high level of debt. Generally, I will look for an ROA of at least 10% but may accept a lower return depending on the industry average.
As a dividend investor, I want to see a yield of at least 2% but am skeptical of companies that pay more than an 8% yield. Outside of REITs and other special situations, it is tough to pay an 8%+ yield and still retain enough cash to grow the company. A history of dividend increases is important to gauge management’s commitment to cash returns.
American Railcar Industries (ARII) designs, manufactures and sells railcars as well as provides after-market servicing. The company provides cars for transportation of a range of products but the real growth is coming from energy transportation. The boom in oil & gas production is outpacing pipeline growth and rail transport will be strong for years to come.
Sales have increased for the last three consecutive years but are still below their 2008 high. The company has been investing heavily over the past couple of years and posts a 12% return on assets.
The shares pay a 2.3% yield but should increase over the next few years on higher free cash flow as capital expenditures slow. Mexico just passed an historic bill to increase its own energy production and the rest of North America is on track for record production over the next decade. Pipeline growth is being held back by environmental groups and rail transportation is the only other viable mode.
National CineMedia (NCMI) operates a theatre advertising network in the United States, segmented by Fathom Events and traditional advertising. The company’s reach spans more than 19,000 screens in 48 states and the District of Columbia. As viewer engagement becomes increasingly difficult in an online world, movie-goers remain one of the last captive audiences for advertisers.
Sales have increased for seven consecutive years, a strong accomplishment for an entertainment company through the 2009 recession. The company’s is able to squeeze a return of almost 14% on its assets and has $127 million of cash on the balance sheet.
The shares pay a 4.6% yield and the payout has increased by an annualized 7% since 2007. While the 2013 movie lineup was not particularly strong, there are enough blockbusters planned for 2014 and 2015 that the company could see strong sales growth.
Of the almost 2,000 small-cap stocks in my screening universe, 500 of them pay dividend yields of between 2% and 8% but only half of those are able to boast a return on assets of 10% or more. The list of potential candidates gets extremely thin when you add sales and dividend growth to the search but resist the urge to weaken your criteria. Small cap stocks can provide both growth and cash returns but the higher risk has to be managed with a closer analysis.