How to Research Small Cap Dividend-Paying Stocks

The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best. - Howard Marks

A few years ago, my wife and I were vacationing on an island in North Carolina and spent some of our downtime combing the beaches for seashells. We weren't having much luck finding good specimens on the popular main beaches that were picked over by other tourists, so we decided to kayak to a more remote area of the island where the sea met the sound to see if that improved our fortunes.

Indeed it did. Within a few minutes on the less-traveled shoreline, we found better shells than we'd found in a few days on the popular beaches, including a relatively hard-to-find intact Scotch bonnet shell.

The Scotch bonnet: the state shell of North Carolina

There are clear parallels for us as investors. So much of the market's attention is focused on the largest companies that finding deeply undervalued companies among them is rare. Like patrolling the popular beaches for good shells, the only times you're likely to find treasure among large cap stocks is right after a storm when everyone is still taking shelter.

Few bargains today

This was very much the case in the years immediately following the financial crisis when many quality large caps were trading with attractive yields over 3%. Even as late as December 2011, the S&P Dividend Aristocrats Index, which consists of S&P 500 companies that have raised their payouts for at least 25 consecutive years, yielded 2.7%.

Unfortunately, the quality large-cap dividend beach is now as crowded as Panama City on spring break and deep values and attractive yields are thus harder to come by. Of the 53 current S&P Dividend Aristocrats, for instance, only 13 currently trade with dividend yields over 3%.

It's important to keep in mind that the universe of high-quality large cap dividend-paying stocks is relatively small. When we also consider that in the last two years alone, $39 billion flowed to dividend-themed ETFs (most of which are heavily large-cap focused) alone, it's easy to see how valuations have become stretched and yields depressed.

Where to look 

If your aim is to invest in the dividend stocks with best chance of outperforming in the coming years, your energy is best spent in areas of the market with less investor interest.

I'd start with sorting through a list of global smaller-cap dividend payers. As the following table from Royce Funds shows, there are not only a larger number of higher-yielding stocks to consider, but, as smaller companies, these names are less likely to be well-covered and are more likely to be mis-priced. (Of course, they can be mis-priced to the upside as well as the downside, so be sure to do your due diligence before investing.)

Source: Royce Funds

When evaluating small cap dividend-paying stocks, I look for the following attributes:

1. Low debt or preferably no debt. More 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. 
2. An invested leadership team. Unless they are founders themselves, executives at large companies are unlikely to own a meaningful percentage of the company. To own 1% of a $50 billion company, for example, would require an ownership stake of $500 million. Small cap executives, on the other hand, can more reasonably own a good stake of the business. With small caps, I like to see insiders own at least 5% of the company as it should motivate them to allocate capital with a long-term ownership perspective since they have skin in the game. 
3. 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. 
4. Dominant in a profitable market niche. Small companies with dominant shares of niche markets are less likely to attract the attention of large competitors. In many cases, the niche is too small to make a difference for the large competitors and if the niche is attractive enough, the larger companies are more likely to simply acquire the dominant player instead of entering the market themselves. 
5. 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. 
6. 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. 
7. Pricing power. If a company can steadily raise its prices on customers each year without losing a meaningful amount of business, it will go a long way toward supporting the current dividend payout and fueling dividend growth for years to come. If the company can't consistently raise prices, it probably doesn't have a durable competitive advantage and it therefore becomes more difficult for the company to protect margins and raise the dividend at a good pace each year. (If they're price-takers, make sure they are low-cost producers.) 

Researching smaller cap dividend-paying stocks requires a bit more legwork than researching large caps where information and analysis is more plentiful, but if you want a chance to beat the market by a meaningful margin over the longer-term, it's the right place for dividend-minded individual investors to spend a good chunk of our research time. 

Related posts

• Exploit Your Advantages as an Individual Investor
• Where to Find Differentiated Dividend Ideas
• The Benefits of a Focused Investing Approach

What I've been reading/watching this week:

• How memories shape market cycles - A Wealth of Common Sense
• Animating Mr. Market - Michael Mauboussin
• Daejan: 259-Fold Gain over 55 Years - Maynard Paton
• The fear of missing out vs. the fear of holding the bag - Howard Lindzon
• Latest issue of Graham & Doddsville - Columbia Business School
• Akre Capital 1988 shareholder letter - Akre Capital
• Finding the right broker for you (UK) - Monevator
• What Pat Dorsey looks for beyond economic moats - ValueWalk
• An evening with a portfolio manager (30 years ago) - Tom Brakke
• Warren Buffett is a closet technical trader (?!) - Midnight Trader
• Two hedge fund managers walk into a bar - Morgan Housel
• The riddle of Tampa Bay - CIO

Stay patient, stay focused.

Best,

Todd


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Better Buying Opportunities Coming for Dividend Investors

In 2005, I distinctly recall perusing the Barnes & Noble business section for a book on dividend investing, only to find just one book that specifically addressed the topic. (There are, um, quite a few more available today on Amazon.com.)

Things changed with the financial crisis, as we know. Interest rates plunged and dividend stocks rapidly became an attractive alternative for income-seeking investors. 

Indeed, the Google Trends chart for the search term “dividend stocks” illustrates the changes in sentiment from 2004 to present quite nicely:

Source: Google Trends

Naturally, the financial services industry responded to strong investor demand for dividends by launching dividend-themed ETFs, ETNs, and funds to attract assets. Some are more creative than others, but when there's a revenue-weighted dividend ETF (not kidding), you know folks are running out of ideas.

Fortunately, it seems we're past the "peak" for dividend valuations, investor interest appears to be turning elsewhere, and more long-term buying opportunities could thus present themselves.

"Non-dividend stocks have outperformed dividend stocks in the S&P 500 over a one year timeframe. Prior to this period, nonpayers had underperformed dividend stocks since late 2009."  - FactSet Dividend Quarterly, September 2013

Just this week, in fact, I started a position in Coca-Cola -- my first buy this year for the dividend sleeve of my portfolio -- and found it interesting that the stock was yielding over 3% for the first time since 2010. 

Though low interest rates may be around a little longer, the prospect of rising interest rates in the coming years should at least limit further multiple expansion for higher-yielding dividend stocks. In the event of a market pull-back and considering the robust dividend growth we've seen in the last three years, I would expect to see more quality 3% to 5% yields coming available. 

Stay focused and patient out there.

Best,

Todd
@toddwenning

Good reads this week

• "Living in a Low Return World" -- Abnormal Returns  
• "Buffett's Folly: The Downside of Compound Interest" -- Monevator
• "Dividend Compass Cup" -- Total Return Investor
• "What Ponds are You Fishing In?" -- Oddball Stocks

Quote of the Week

"My father was very sure about certain matters pertaining to the universe. To him, all good things -- trout as well as eternal salvation -- come by grace and grace comes by art and art does not come easy." -- Norman Maclean, "A River Runs Through It" 

Can a Total Shareholder Yield ETF Work?

A rare mid-week post, but earlier today I read an interesting article on Forbes about the Cambria Shareholder Yield ETF (SYLD), which was based on an interview with the Cambria CIO. So I decided to dig into the story a little this evening.

The SYLD ETF is slightly different from the growing number of dividend ETFs on the market today in that it doesn't focus solely on dividends, but also includes buybacks and debt reduction in its algorithm. From the Cambria site:

The Cambria Shareholder Yield ETF is an actively managed fund that employs the manager's quantitative algorithm to select U.S. listed companies that show strong characteristics in returning free cash flow to their shareholders. Specifically, SYLD invests in 100 stocks with market caps greater than $200 million that rank among the highest in (a) paying cash dividends, (b) engaging in net share repurchases, and (c) paying down debt on their balance sheets.

It's a novel approach for sure and investors should certainly pay attention to buybacks and debt when analyzing individual companies. (I particularly liked the CIO's mention in the Forbes article about watching out for high-yielding stocks that are also increasing their share count. A good tip!)

Though I give Cambria credit for trying something different, after reading the SYLD ETF's prospectus, I'm not sure it will work as an ETF or formula-based strategy.

As we discussed in an earlier post, though buybacks are becoming a larger part of corporate distributions, I don't think a "total yield" measure can replace dividend yield.

Source: Birinyi Associates and FRB Z.1.

The obvious reason is that buybacks remain a choice rather than a commitment. In a given year or two, a company could dramatically pull back on buybacks and the "total yield" shrivels up. (It's true that a company could also cut its dividend, but this would be much harder to do given different shareholder expectations.)

To Cambria's credit, they are looking to invest in companies with a systematic approach to buybacks, but this puts enormous faith in management's ability to have a good buyback process. How Cambria measures this in its security selection algorithm is not disclosed, but it seems to be a challenging task using a strictly quantitative process.

As we've seen, many companies end up buying back stock when they have excess cash...which also tends to be when their share price is higher. In my experience, I've come across very few companies with a rational and disciplined approach to buybacks.

I'm also not clear on why debt reduction should be considered part of "shareholder yield." At face value, less debt on a balance sheet seems desirable, but it's also possible for companies to be underlevered. In this case, companies should take on more debt to reduce their overall cost of capital. Further, and more to the point, the cash return is to bondholders and not shareholders.

Perhaps the answer to the net debt reduction question lies in the prospectus, which notes that the measure of dividends, net buybacks, and net debt reduction cash flows:

"in isolation, is inadequate to determine the attractiveness of its equity securities, considered together these measures have the potential to result in the construction of a portfolio of companies with better cash flows, stronger growth potential and higher yield characteristics. Considering these measures together, which comprise shareholder yield, may result in a more attractive investment portfolio." (My emphasis)

If I were considering SYLD I would ask whether or not net debt reduction was simply a "plug" figure in the formula that made the algorithm look more predictive than dividends and net buybacks alone. Best case is the ETF is looking for firms that can return cash via dividends and buybacks without borrowing, but if that's the case, it should be more explicit in the prospectus.

I realize I've been critical of most of the new ETFs out there, but I also think it's important to look behind the alluring stories in the ETF launch material. Ultimately, I remain convinced that investors are best served building their own dividend-focused portfolio one stock at a time with thorough research.

I'm interested to hear what you think, so please let me know in the comments below or on Twitter @toddwenning.

Best,

Todd

Should You Buy This New Dividend ETN?

Earlier this week, a friend recommended I take a look at this excellent post by Interactive Investor (UK) writer Richard Beddard that highlighted a recently launched dividend strategy from SocGen called the "SG Quality Income Index".

Assuming the backtest is accurate, the results of the SGQI index are intriguing:

Admittedly, I have been unable to find SG's original white paper on the Quality Income Index (if you have a copy, please let me know), but judging from the prospectus for a security linked to the QI index, here's the rundown: 

The SG Global Quality Income Index (the Index) (Bloomberg: SGQINTR) is based on two basic principles. The first is that historically dividend yield represents the biggest component of equity returns and the second is that often equity investors are not rewarded for buying higher risk stocks. (my emphasis)

I've picked up from various other sites that the SGQI index also focuses on dividend sustainability and balance sheet strength while giving less value to traditional dividend cover metrics ("Our research suggests that good dividend cover is not a good indicator of how safe that dividend is in the future"). 

So is the SGQI the perfect methodology for approaching dividend investing? From what I've read thus far, I agree with some points and others I have remain skeptical about.

Where I Agree

#1: Dividend paying stocks as a group tend to outperform

There's nothing revolutionary about SGQI's findings, as there are myriad studies supporting dividend-paying stocks (as a group) outperforming the market. Here are two practical reasons why I believe these studies have merit.

First, dividend payouts are "sticky" -- once they're started they're difficult to reduce or eliminate -- so management has to consider those regular cash outflows when making capital allocation decisions. A management team flush with cash is like the proverbial man with a hammer and they are prone to "empire building" through a rash of acquisitions. After all, it's in their best interest -- the bigger the company becomes the more they can demand from a pay perspective. Sadly, acquisitions (especially large ones) typically benefit the shareholders of the acquired company and not those of the acquirer. Having a regular dividend cash outflow, therefore, reduces the pile of cash at management's disposal and reduces the odds that management will invest in acquisitions that destroy shareholder value.

Second, a company that pays a regular and (ideally) an increasing dividend is more likely to be confident in the longer-term prospects for the company. By regularly increasing the dividend, management is indicating that it believes it will be able to afford that payout in the future. In addition, paying a regular dividend allows shareholders to immediately share in the company's success and realize cash flows alongside the company. Non-dividend paying companies, on the other hand, retain all cash flows to reinvest in the business and are thus implying that they can earn a higher rate of return on your cash than you could if they handed it back to you. There are some rare cases (think Apple under Steve Jobs) where that's reasonable and desirable, but it's not common for companies to be able to consistently reinvest all their cash at rates above their cost of capital.

#2: Balance sheet health is important

Rapidly deteriorating balance sheet health was one of the major reasons that companies cut their dividends during the financial crisis. Indeed, 2007 set M&A records and a good number of companies overextended themselves with acquisitions thinking the good times would continue. When the financial crisis hit, these companies were often in danger of breaking their debt covenants, risked credit rating downgrades, or struggled to refinance near-maturity debt. As a result, dividend payouts were naturally cut in an effort to shore up cash and repair balance sheet strength.

To reduce the risk of balance sheet-induced dividend cuts, I look at a company's interest coverage (EBIT/interest expense) track record and want to see at least 3x cover on a consistent basis. Another good rule-of-thumb is to avoid companies with net debt-to-EBITDA ratios above 2x. Unless that company has sustainable competitive advantages and stable margins, an economic downturn could quickly call its dividend into question.

#3: Underlying business economics matter

SG stresses that quality income payers must have both a robust balance sheet and robust underlying business economics. Indeed, it is critical to have both.

A firm with a solid balance sheet, but deteriorating business fundamentals won't likely make for a great investment. Eastman Kodak, for instance, had a pretty solid balance sheet in the late 1990s, but its business economics were beginning to deteriorate as digital photography stole share from Kodak film. That's why it's critical to frequently assess the strength of a company's competitve position -- are there new substitute products, new or strengthening competitors, a loss of an imporant patent, etc. that could impair the company's ability to generate strong returns?

If the company's competitive position is deteriorating, it's probably best to pass on it as an investment even if it's currently in good financial health.

#4: Don't chase yield

As I've said before, ultra-high dividend yields can mean ultra-high risk of a dividend cut. The market doesn't often give away low-risk 8%-plus yields, so it pays to be skeptical of any yield that seems too good to be true. I really liked this chart that SG put together that compares realized and forecast dividend yields and provides statistical support to the notion that the higher the initial yield, the more likely that yield is unsustainable.

#5: Boring stocks are often undervalued

In The Future for Investors, Wharton professor Jeremy Siegel revealed the best performing U.S. stocks between 1957 and 2003. The best performing stock was tobacco giant Philip Morris (now Altria), which generated an incredible 19.75% annualized return over that period. Other top-performers on the list included Coca-Cola, Pfizer, Heinz, Unilever, and Wrigley. These companies may not have operated high-octane businesses, but they earned steady profits and had sustainable competitive advantages that helped them maintain pricing power over many decades. This translated into incredible returns for their long-term shareholders.

Indeed, in Peter Lynch's classic One Up on Wall Street, he lists thirteen signs of an attactive stock. Among them are several recommendations to look for "boring" stocks, including: It sounds dull - or, even better, ridiculous; It does something dull; It does something disagreeable; There's something depressing about it; and It's a no-growth industry.

Boring, high-quality stocks are attractive long-term investments precisely because they aren't going to grab a lot of investor attention and are thus more likely to be undervalued. Who wants to brag to their friends that they picked up 1,000 shares of a company that makes cleaning products? It's much more fun to talk about the stocks du jour -- the Facebooks of the world. Financial headlines love a good high-growth story and you won't see the FT flashing a story about a company that's raised its dividend for 10 years in a row, but the latter are exactly the types of companies you should look to own as they have been creating real long-term shareholder value.

Reasons to be skeptical

#1: Always be wary of backtests

The SGQI backtest reminded me of the backtests done by WisdomTree when it was launching its line of dividend-weighted ETFs. As I wrote in 2009, WisdomTree's dividend-weighted model supposedly would have worked great in the past, but struggled to produce the same results when the dividend landscape dramatically changed during the financial crisis amid the hundreds of dividend cuts between 2008 and 2009.

Judging from the performance chart (the first one on this page), SG studied the period 1989-2011. 22 years is a decent amount of time, but the data population is relatively small (8,030 days) and subject to more error.

SG's backtest also assumes no transaction costs or commissions -- both of these things (as well as taxes) are critical components to realized returns and can't be overlooked.

Backtesting is a fine way to test a strategy or theory -- so I'm not critical of SG using a backtest -- but it's important to take backtests with a grain of salt as they are backward looking and investing is a forward-looking activity. Specialized or formula-based strategies that worked in the past may not work in the future.

#2: Pre-buybacks

A lot has changed in the dividend world since 1970. At the time, stock buybacks were essentially non-existent and cash dividends were the primary way of returning shareholder cash. Today, a lot of companies prefer buybacks to dividends for a number of reasons -- they aren't as sticky as dividends, they can artificially increase EPS, and can increase financial leverage.

Even though I prefer dividends to buybacks (a subject for another post), there's no doubt that buybacks are now a force to be reckoned with and thus should be considered in any dividend-focused backtest:

Source: Aswath Damodaran

#3: Dividend yield as the biggest component of equity returns

Recall that expected return is approximately equal to starting dividend yield + dividend growth +/- P/E re-rating.

SG argues that dividend yield was the biggest component of equity returns between 1970 and 2011. That might be true and I don't have all the data they used to compile their chart (the second chart from the top), but using some annual data for the S&P 500 between 1960 and 2011, I put their findings to the test.

I took the starting dividend yields each year between 1960 and 2001 and measured the rolling 10-year annualized changes in dividend growth and P/E over the subsequent 10-year period.

Data Source: Aswath Damodaran

My (less scientific...hopefully) findings were a little different from SG's. The median dividend yield over this period was 3.4%, the rolling 10 year median dividend growth was 5.4%, and P/E contribution was 0.5%. My data seems to suggest that it's, in fact, dividend growth and not dividend yield that has been the primary driver of long-term equity returns. At least in the U.S.

Moreover, average dividend yields were much higher in 1970 than today -- 3.46% in 1970 vs. 2.07% in 2011 -- so SG's results might be a function of the chosen starting year. Thanks to the widespread use of buybacks as an alternative to dividends, I don't think we'll get back to consistent 3%-plus average dividend yields in the U.S., so I doubt that dividend yield will be the largest component of equity returns over the next 40 years.

#4: Dividend cover less important

I do agree with SG that balance sheet health needs to be considered when evaluating the quality of a dividend-paying stock, but I would be interested to see the data behind their claim that dividend cover was not a good indicator of dividend sustainability. Intuitively it doesn't make sense. A company that consistently covers each dollar of dividend with $3 in free cash and earnings will likely pay a more sustainable dividend than one that covers each dollar with $1.20 in free cash and earnings. 

If they were using annual dividend cover data rather than normalized dividend cover data (a five year average), I can see why dividend cover metrics may be less explanatory. That's because in any given year highly cyclical companies may have great coverage metrics if the economy is strong, but the coverage can quickly deteriorate in a recessionary year.

When you're measuring a company's dividend health, I recommend using at least five years of data (preferably more, if available) to see how dividend cover has changed over the years. For cyclical companies, use normalized figures to avoid the trap of misleading fundamentals in peak years.

#5: Lots of money flowing to dividends

I wasn't at all surprised to hear that SG was launching an ETN that tracks the QI index. Fact is, with bond rates so low right now there's a ton of money flowing into dividend-focused ETFs and funds, and just like any industry that's receiving a lot of capital it naturally inspires innovation in the space. Looking back, some of those innovations will be helpful to investors while others won't. Therefore, it's important for investors to be skeptical of any new mouse-trap aimed at dividend investing today.

#6 Dividend paying stocks are not like bonds

In SG's advert for the QI ETN, they state: "quality income stocks can provide the bond-like characteristics of income and capital safety, but also offer scope for capital growth like equities." If that sounds too good to be true, that's because it is.

With a stock (no matter how high quality it might be), your principal and dividends are at total risk, whereas with bonds there's a contractual obligation for the company to pay you back interest and principal on certain dates. What SG is actually describing in that sentence are convertible bonds that allow you to convert your bond into equity at a predetermined price if the stock price rises, but also offers downside protection in that you can simply hold the bond to maturity if the stock declines.

While I think that income-minded investors with a long time horizon should consider a diversified dividend-portfolio in this low bond-rate environment (in the context of their individual risk tolerance, investment objectives, etc.), it needs to be made clear that bonds and stocks have very different risk profiles.

Bottom line

I applaud SG for adding additional insight and research into the field of dividend investing, but I won't be purchasing the QI ETN.

(Note: I had some publishing problems with this post. If you notice any minor changes, it's because I had to rewrite some sections.)
--

A few good reads this week:

Howard Marks' new memo on risk and hedging.
Monevator (UK) on the absurd levels of banker pay.
Is manufacturing moving back to the US? (The Atlantic)

And finally...what cricket looks like to Americans:

 Have a good weekend!

Todd
@toddwenning on Twitter