Most investors looking for equity dividend income turn to the same six old names, even if the threat of another dividend cut hovers just overhead. However, dividend champions are on offer among small-cap stocks, which we define here as having a market cap of less than $5 billion, in other words, ex-ASX50.
The question is of course how to find them without getting stuck in a dividend trap. To show how the best-in-class fund managers approach this worthwhile challenge, we approached Jack Collopy from Perpetual Investments; Marc Whittaker from Investors Mutual and Matt Williams from Airlie Funds Management to demonstrate their processes.
In this first of three wires, we ask our experts how they start off by narrowing the field and to share the results of the names that passed their filters.
5 names that tick all the boxes
Jack Collopy, Perpetual Investments
It’s very easy to fall into the trap of just screening for stocks with high dividend yields.
However, what matters more is the sustainability of the earnings that support those dividends.
Before even thinking about the yield on offer, we want to get comfortable that a company will be able to sustain – and ideally grow – its earnings over time, without taking on an unnecessary level of debt.
We are very strict when it comes to assessing the quality of a company’s balance sheet as well as the recurring nature of its earnings.
If we were to run a screen for quality income-producing stocks, we’d start by looking for companies with
A track record of steady profitability and
A dividend policy which doesn’t constrain management’s ability to reinvest in the business.
Some names which tick these boxes for us include:
Five qualities we look for in a company
Our five-part screening process makes up the mantra which has been at the heart of our investment decision-making since we opened 21 years ago.
We look for quality companies with:
A competitive advantage,
A history of consistent, recurring earnings,
The ability to grow earnings and
All at a reasonable price.
Yield has always been an important component of returns in the small-cap sector. While a company’s ability to grow is desirable, companies that can pay a sustainable, consistent and growing yield over time should be a consideration in every portfolio.
Our focus on quality and value culls many stocks from the list, leaving a list of what we believe to be potentially superior investment opportunities. Dividend streams and supporting cash flows are, then, a key factor in our portfolio construction.
Here are some of the top 10 small-cap income stocks, in order of yield, that have passed our screening process and successfully made it into IML small-company portfolios:
The results of a three-point checklist
Matt Williams, Airlie Funds Management
The screen I’ve run first of all ignores dividend yields, and screens for financial strength instead.
To protect capital and to hopefully ensure the sustainability of dividend payments, I’ve screened for the following criteria from a field of stocks with a market cap less than $5 billion.
Interest cover >5x
Payout ratio <80%
Net debt/EBITA <3x
You can see the results of the screen in the spreadsheet on the spreadsheet which is available here. To help orientate you, the column on the far right showing ‘Total meets’ shows the number of times that one of the three conditions above has been met. In the three columns to the left of that, you can see which of these conditions have been met.
Having screened to create a shortlist I then qualitatively assess each company on:
the quality of business which feeds into the sustainability of the dividend.
the strength of the management team including what I know of their capital management framework and track record.
Dividend traps and top picks
If you enjoyed the responses from Jack, Marc and Matt above, watch out for the next two wires in which they discuss the big risks to consider when investing in small-cap income stocks, and their nomination for their top pick in this space. Hit FOLLOW to get it first.
Wow, that screen from Matt Williams is awesome. Such a great insight into the process.
KSL has a with local with holding tax that would need to be taken into account for a true return
Vince, can you please explain where you get a yield of 8.3% for URW?
Yes James, I agree Matt's spreadsheet is a cracker. Another article well put together with some excellent ideas. Great job thank you Alex.