Many investors associate dividend investing strictly with owning slow-and-steady blue chip shares. And whilst larger companies can be an important foundation in an income producing portfolio, dividend-minded investors shouldn't forget about small cap opportunities.
Indeed, one of the key advantages of being an investor with a smaller capital base is that we can make meaningful investments in promising smaller companies without distorting the share price. Large institutions with billions of pounds to invest simply cannot do the same, which makes the small cap area of the market such fertile ground for investors like us. As Warren Buffett once put it, "It's a huge structural advantage not to have a lot of money."
Granted, small-cap shares can at times be much more volatile than larger ones, so it's even more important to be selective and have a long time horizon when searching for opportunities in this area of the market.
One of the key factors that I look for in a promising small cap is a good dividend track record. To me, this not only shows that the company has consistently generated positive cash flows (not always a given for small caps), but also that the board is confident in the business's prospects and has shown a willingness to share the company's prosperity with shareholders.
As such, here are three small cap dividend-paying shares that I've recently come across that are worth adding to your portfolio watchlist for further research.
Portmeirion (PMP)
- Market capitalisation: £70 million
- Dividend yield: 3.3%
- Sector: Consumer Goods
You may have some of Portmeirion's homeware products in your cupboard today. The company makes higher-end tableware and cookware under the Portmeirion, Spode, Royal Worcester and Pimpernel brands. Its major markets include the US, UK and South Korea, which is a fair amount of global reach for a smaller company.
Though serving dishes and tea sets may not seem the most exciting of businesses, Portmeirion's operation is quite profitable with operating margins and return on equity averaging around 10% and 14% since 2006. Further, the company did not cut its dividend during the financial crisis when many other consumer-facing companies did and has increased its payout by an average of 10.4% per annum since the end of 2008. With earnings-based dividend cover over two times and a debt-free balance sheet with £7.5 million cash, Portmeirion's dividend looks secure.
On a free cash flow basis, however, the dividend cover was just 1.1 times in 2012 due primarily to some working capital issues. As such, investors would be wise to keep an eye on the free cash flow cover, but Portmeirion appears to be one of those "under the radar" small caps to keep an eye on.
Latchways (LTC)
- Market capitalisation: £134 million
- Dividend yield: 3.0%
- Sector: Industrials
Looking across Chicago's skyline from my desk at Morningstar headquarters, I can see a handful of window washers and construction workers suspended more than a hundred feet in the air. All I can think is, "I hope they're getting paid well." They also must put a lot of faith in their fall protection systems—the harnesses, cables and anchors—that keep them securely aloft and I'd imagine that in that line of work you quickly become brand-loyal to a particular system that has proven effective.
Few workers (and their employers) would be willing to save a little money to test a new and unproven fall protection system as the potential costs from failure would likely outweigh the upfront savings. It's because of this meaningful switching cost that I think Latchways and its ManSafe fall protection systems make for an intriguing and potentially-‘moaty’ business. Further, Latchways could benefit from the rising tide of more industries and government regulators improving health and safety standards for workers.
Financially, Latchways has a track record of consistently raising its payout (11% compounded since 2008), has no debt and is inclined to pay special dividends in particularly good years, as it did in 2012. Encouragingly, the current dividend is covered more than twice-over by earnings and 1.7 times on a free cash basis.
Stanley Gibbons (SGI)
- Market capitalisation: £80 million
- Dividend yield: 2.3%
- Sector: Consumer Goods
Two of investing legend Peter Lynch's signs of a perfect stock are "it does something dull" and "it's got a niche." Though passionate philatelists around the world might disagree with me on the first point, I bet we can all agree that stamp trading is a niche. With a history stretching back to 1856 and a century-old royal warrant issued by George V in hand, Stanley Gibbons certainly possesses a recognisable brand in the stamp dealing industry.
Though Stanley Gibbons also deals in other collectibles, philatelic trading and accessory sales account for the vast majority of the company's revenue and profit. Frankly, I was surprised to see that stamp business was so profitable—between 2007 and 2012, Stanley Gibbons' net margins and return of equity have averaged 15% and 21%, respectively—and over the past five years the dividend has grown at 7.6% per annum on a compounding basis.
At year-end 2012, the dividend was covered more than three-times over by earnings and the balance sheet is healthy with a £6.6 million net cash position. The collectibles industry is naturally volatile, so a conservative approach to dividend policy and capital structure is indeed prudent.
Bottom Line
Even if you keep the bulk of your dividend-focused portfolio in larger shares, if you also have a long time horizon, have the requisite patience and seek strong dividend growth opportunities, don't forget about small cap shares. And with many AIM-listed shares becoming eligible for inclusion in the tax-free ISA wrapper this autumn, small caps can now more easily bolt on to your current ISA strategy.
Finally, if you do decide to buy small-cap shares, be sure to use limit orders as the bid-ask spreads on less frequently traded shares can be rather wide.
