Looking for Big Dividends? Think Small (Caps)

By Brian Shaw - August 28, 2012 | Tickers: ASEI, CWT, CGNX, CLCT, GOV | 0 Comments

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The first place that investors typically look for companies to populate an income-producing portfolio are well known mega caps such as Coca-Cola, Johnson & Johnson, Procter & Gamble.  To be clear, these companies are excellent candidates for dividend portfolios given the stability created by the long history of reliable dividend growth that has earned each company a spot on the elite list of dividend aristocrats.  In fact, I recently wrote about some of the new members of that exclusive list that might also be solid candidates for a wide range of investors’ portfolios.

In addition to these well-known large companies, don’t forget about small cap stocks when adding dividend paying stocks to a portfolio.  There are a number of companies generating consistent cash flows and returning healthy dividends to shareholders that deserve consideration despite being smaller in size and perhaps less recognizable to the average consumer.  Here’s a look at five candidates that fit this mold.

American Science and Engineering (NASDAQ: ASEI) is a name that you may not have heard of, but the company manufacturers a wide array of state-of-the-art x-ray inspection products.  These devices can be used on people, vehicles, cargo, baggage and more.   Fortunately for this company (and unfortunately for society), the demand for constant improvement in detection devices is not likely to go away anytime soon.   The company began paying a dividend about five years ago and sports a dividend yield of 3.3% at today’s prices. 

Government Properties Income Trust (NYSE: GOV) is a small cap that has carved an interesting niche amongst REITs; two thirds of the company's revenue is generated from properties leased to the U.S. government.   With another 20% leased by state governments and 5% leased by the United Nations, Government Properties has perhaps the most credit-worthy lineup of tenants of any REIT.   In addition, Government Properties’ current yield of 7.7%, its comfortable debt to equity ratio and its history of growing its dividend payments since its IPO in 2009 all point towards a well run company returning substantial capital to investors. 

California Water Service Group (NYSE: CWT) provides over two million people with water and wastewater utility services in the western United States.  The investment thesis behind the country’s growing demand for drinkable water is undeniable, which gives companies like CWT a tremendous degree of stability.  This stability is emphasized by the company’s recent announcement of its 270^th consecutive quarterly dividend.  With a yield of 3.4% and a history of growing dividend payments, CWT is not far from the Coca-Colas of the world in terms of consistent income producers; as shown in the chart below, shares of CWT purchased 10 years ago would have an effective dividend yield today of over 12% of the original purchase price as a result of regular dividend increases:

Collector’s Universe (NASDAQ: CLCT) runs a niche business that authenticates and grades collectibles such as coins, autographs, trading cards and other memorabilia.  These services require few fixed assets and generate strong margins, resulting in significant cash flow made available to investors.   With a healthy cash hoard and no debt, management has been able to return significant portions of this cash flow to investors.  In fact, the TTM dividend yield for Collector’s Universe is an impressive 8.6%.

Finally, Cognex (NASDAQ: CGNX) creates machine vision solutions that assist with quality control, manufacturing, tracking and logistical applications around the world.   Said differently, Cognex creates machines that can visually inspect products for the smallest imperfections or read damaged barcodes that the standard scanner cannot.  Cognex has been paying a dividend since 2003, and while the TTM dividend yield is only 1.2%, Cognex has commenced a regular program of dividend increases that is unlikely to end soon based on the company’s current 24% payout ratio and growing earnings.

Here's a more in depth look at the trend in dividend yield for each of these companies since the beginning of 2010:

Before getting too excited by the apparent trend of reliable dividends from these small caps, it is critical to look at the overall health of each company's financial statements:

Each of the five companies listed above is solidly profitable, has a reasonable valuation, a managable amount of debt (if any) and has paid a steady stream of dividend payments over the past few years.  However, as with any dividend payer, it is important to monitor the strength of the underlying business and the company's payout ratio to ensure that the company can continue paying dividends in the future.  REITs such as Government Properties and utilities such as California Water Trust typically have high payout ratios, so the numbers in the table above aren't of particular concern.  

American Science and Engineering's 81% payout ratio is the result of the lumpiness of the company's business combined with the recent struggles it has faced as a result of tightened government spending across the globe; I'd give this company a caution flag on the health of its dividend payment, but there's no immediate cause for concern with $185 million in net cash on the company's balance sheet.  Collector's Universe's 188% payout ratio is definitely a red flag in my opinion; while a company's desire to return capital to shareholders is a good thing, it is questionable if this dividend can be maintained over the long haul.  That leaves us with Cognex; despite having the lowest dividend yield of the group, the company is growing its dividend at a conservative (and very sustainable) pace while it continues to generate earnings growth.   This mix of growth and income is an appealing combination, although the higher yielding options are solid choices as well for anyone that is focused on income only.

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