Finding value in small caps through an income and capital growth lens

For most Australian investors, portfolio construction is heavily focused on yield, often with limited consideration given to capital growth or capital at risk. By overlooking the capital component of return, investors can miss a significant opportunity to generate a materially higher future income stream from their portfolio.

Income and capital growth are not opposing forces; in fact, over the longer term they often travel together. Capital growth expands the value of a portfolio, creating a larger base from which income can be generated in the future. There are many compelling opportunities offering attractive yields alongside capital growth if investors are willing to look beyond the ASX200, opening a broader opportunity set for those prepared to think differently about where their income can come from.

The hidden risk in chasing yield

Focusing solely on investing for a high yield today can come at the expense of tomorrow’s income. A high yield may look appealing on the surface, but it is critical to understand how that income is generated and, more importantly, whether it can grow over time. One of the challenges businesses have is they often must reinvest cash profits to grow, at the expense of paying dividends. However, a well-established business with a high return on capital and generating free cash flow can do both. Of course, there is a lot more to consider but focusing on free cash flow and stay in business capital expenditure is a good place to start in assessing a business’s ability to grow while distributing income.

If a stock is trading at a high-yield, it is critical to consider why. It often means the level of income being paid to investors is not sustainable or funded via debt and balance sheet leverage meaning it will likely be reduced or there is a high level of capital risk. The market believes the high yield will eventually correct - either through a reduction in income or the share price. On the other hand, a high yield can reflect a genuine mispricing - an opportunity where income is sustainable and capital upside exists.

How Ryder Capital thinks about income and growth

We love to find opportunities that can pay us regular and ideally increasing income in the form of fully franked dividends while growing in capital value over time – this is investor nirvana!

A great example of a business we own that is growing whilst paying regular and increasing fully franked dividends is Count Limited (ASX: CUP). Count is a growing network of integrated Australian accounting and financial advice firms that trades on a low earnings multiple, and an attractive 4.1% fully franked trailing dividend yield (at $1.10). Importantly this dividend is fully funded by the strong free cash flow generation of the business, after investing the capital required to grow. 

Over the last 5 years, earnings have grown in total by 92% whilst the annual dividend has increased by 80% and we expect earnings and dividends to continue to grow.

Just as importantly, we think Count is undervalued based on our assessment of its intrinsic worth, providing confidence that our future forecast income return will not be eroded by a falling share price. In fact, we think quite the opposite is likely. This approach in identifying undervalued companies capable of generating capital gains while paying sustainable and growing income underpins how we invest across the portfolio and has allowed our own listed investment company - Ryder Capital Limited (ASX: RYD) to grow its own capital value whilst paying increasing fully franked dividends, something we have achieved every year. Since our first dividend in FY18 of 3c, RYD is now paying an annual dividend of 12c per share fully franked.

The benefit of a Listed Investment Company (LIC)

Loathed by many and with trading discounts across the sector at cyclical highs, the Australian LIC sector presents a compelling opportunity for long-term, income-focused investors.

Key structural advantages of LIC’s include:

• Flexibility to make discretionary dividend payments and retain earnings to smooth out payments over time, allowing investors to have a reliable and growing source of income even during periods of market volatility
• A permanent capital base allows managers to invest for the long-term without being forced to sell assets to fund redemptions at inopportune times
• With a long-term investment horizon, managers can take advantage of market dislocations such as 2022/2023 when small cap markets experienced significant volatility and underperformance

As an example, despite weak performance in that 2022/2023 period, RYD was able to maintain its dividend due to a strong profits reserve and a considered capital management strategy balancing reinvestment for growth and providing shareholders with reliable and growing fully franked income.

It is important to consider the sustainability of a strong dividend and in the case of an LIC, how well a dividend is supported by its profit reserve, portfolio performance and franking credit balance. With a profits reserve of 48c per share, the current RYD dividend is supported for the next 4 years without considering any further capital profits/income from the portfolio. Trading at a 15% discount to a portfolio of undervalued stocks with upside and a 6% fully franked yield, RYD remains mispriced along with many other LIC’s.

A well-managed LIC that implements cautious, considered capital management strategy over time, by generating consistent returns while not over distributing sugar hits in the good years can be investor nirvana – where there is capital upside with growing regular fully franked income. When capital growth and fully franked income work together, investors can benefit from both income today and a stronger income stream in the future.

This article was co-authored by Peter Constable (Founder and Chairman of Ryder Capital)