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Three small caps with income and growth

Takeovers are ramping up after a Covid induced hiatus. What has this got to do with dividends, you rightly ask.

Acquirers are interested in companies producing good cash flow, which is what investors should be interested in; especially in this situation because it underpins the dividend. The bottom line is it’s a good discipline to look for dividends.

Over the past 4 years we have published a couple of dividend portfolios each year, selected exclusively from our small cap stock universe. We’ve just put another together. How have we gone? Our average return is close to 20% a year versus the S&P/ASX All Ords Accumulation Index return of 7.7%. These portfolios have often benefited from corporate activity. There are always bidders looking at stocks with quality businesses at the small end of town.

Below we discuss more about constructing a 12 strong small caps dividend portfolio, but here are three to get your started.

 

1.     Gale pacific (GAP)

Our patience with the shade cloth manufacturer is paying handsome dividends as US sales and distribution grows. The company still looks good value, trading on a one year forward PE of just over 10 times and we forecast an annual dividend of 2 cents, giving it a dividend yield of 5.4%.  GAP’s earnings are cyclical, but it had the operating cashflow to pay a special 1 cent interim dividend.  It’s not a screaming buy at current levels but its dividend yield should deliver a good cash return at current prices.

 

2.     Southern cross electrical (SXE)

This company installs electricals into big resources projects and through acquisition has diversified its operations into big construction and infrastructure projects in East and West Australia. We like the business because it’s highly specialised and has a history of paying consistent dividends and trades on a yield of 6.4%. Following a difficult first half, a strong rebound is expected in the second half of FY21 driven by Commercial, and a record $500m order book. It has a $700m tender pipeline with resources activity intensifying and an expected resurgence in infrastructure work ahead.

3.     Capral (CAA)

The aluminium products producer has hung in there, having cut its fixed costs in the past few years and thankfully this is paying off, with Covid providing the catalyst for shareholders. Not only is it getting the benefit of recent Federal Government assistance, but due to Covid import dumping has declined and corporate interest in the stock has emerged. The company has turned into a free cash flow machine, trading on a dividend yield of 6.6%.

 

Why under the radar report’s dividend portfolios do well

Money is cheap, big companies are looking for growth and private equity is looking to make money. You might have heard about Macquarie’s MIRA taking over waste management company Bingo for $2.6bn, the attempted takeover of fund administrator Link Administration by high profile private equity funds Pacific Equity and The Carlyle Group, Blackstone’s bid for Crown Resorts or Coke Europe bidding for the ASX listed bottler Coca-Cola Amatil.

The country’s bankers are turning their attention away from IPOs and onto M&A. According to Factset, in the past 12 months in Australia, for deals over $100m, there have been 80 worth $83bn and the vast majority have been at the Small Cap end of the market. Only 20 of the deals were valued at over $1bn. These 60 deals are the ones you might not have heard of.

In our universe there has been the takeover of IT services group RXP Services for a 62% premium by Capgemini; we’ve also had ongoing takeover dramas from private equity interest in troubled beauty products wholesaler McPherson’s (MCP) and aluminium products manufacturer Capral (CAA).

Over the past 4 years we have published a couple of dividend portfolios each year, selected exclusively from our small cap stock universe. We’ve just put another together. How have we gone? Our average return is just under 20% versus the S&P/ASX All Ords Accumulation Index return of 7.7%. These portfolios have often benefited from corporate activity. There are always bidders looking at stocks with quality businesses at the small end of town.

One factor we found was the benefits of diversification. The returns of portfolios with over 10 stocks in them were superior overall to those with eight or less. In our recent reports on constructing a small cap dividend portfolio we showcase the stocks involved and we also highlight some secret benefits of constructing a dividend focused portfolio.

The latest portfolios benefited from a takeover bid for Capral (CAA), which propelled the stock up over 30% before settling back. Small Caps that make a takeover can also perform well because their adding value to a smaller asset base. For instance, Hansen Technologies (HSN) has been reaping the rewards of its Sigma acquisition in 2019.

Sometimes a company that we include in a dividend portfolio doesn’t end up paying one, which can end up being a blessing. A recent example is Alliance Aviation (AQZ) which instead chose to raise funds for a major capacity expansion and to conserve its cash. The market loved the expansion plans, and the stock has performed very well. 

A company’s ability to generate sustainable and growing earnings pays more than just dividends. Even though AQZ didn’t pay a dividend, the capital it raised was for growth, and the stock jumped.

How do we pick them? Fundamental analysis. We look first at operating cash flow versus the total dividend a company could pay. Can it cover its fixed obligations (debt) easily and still pay a dividend? If so, how generous without crimping re-investment. Reinvestment is the key to generating growth. You get that compounding effect from a high return on equity, which builds value exponentially. While that is happening you’re also getting income.

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Why under the radar report’s dividend portfolios do well

Money is cheap, big companies are looking for growth and private equity is looking to make money. You might have heard about Macquarie’s MIRA taking over waste management company Bingo for $2.6bn, the attempted takeover of fund administrator Link Administration by high profile private equity funds Pacific Equity and The Carlyle Group, Blackstone’s bid for Crown Resorts or Coke Europe bidding for the ASX listed bottler Coca-Cola Amatil.

The country’s bankers are turning their attention away from IPOs and onto M&A. According to Factset, in the past 12 months in Australia, for deals over $100m, there have been 80 worth $83bn and the vast majority have been at the Small Cap end of the market. Only 20 of the deals were valued at over $1bn. These 60 deals are the ones you might not have heard of.

In our universe there has been the takeover of IT services group RXP Services for a 62% premium by Capgemini; we’ve also had ongoing takeover dramas from private equity interest in troubled beauty products wholesaler McPherson’s (MCP) and aluminium products manufacturer Capral (CAA).

Over the past 4 years we have published a couple of dividend portfolios each year, selected exclusively from our small cap stock universe. We’ve just put another together. How have we gone? Our average return is just under 20% versus the S&P/ASX All Ords Accumulation Index return of 7.7%. These portfolios have often benefited from corporate activity. There are always bidders looking at stocks with quality businesses at the small end of town.

One factor we found was the benefits of diversification. The returns of portfolios with over 10 stocks in them were superior overall to those with eight or less. In our recent reports on constructing a small cap dividend portfolio we showcase the stocks involved and we also highlight some secret benefits of constructing a dividend focused portfolio.

The latest portfolios benefited from a takeover bid for Capral (CAA), which propelled the stock up over 30% before settling back. Small Caps that make a takeover can also perform well because their adding value to a smaller asset base. For instance, Hansen Technologies (HSN) has been reaping the rewards of its Sigma acquisition in 2019.

Sometimes a company that we include in a dividend portfolio doesn’t end up paying one, which can end up being a blessing. A recent example is Alliance Aviation (AQZ) which instead chose to raise funds for a major capacity expansion and to conserve its cash. The market loved the expansion plans, and the stock has performed very well. 

A company’s ability to generate sustainable and growing earnings pays more than just dividends. Even though AQZ didn’t pay a dividend, the capital it raised was for growth, and the stock jumped.

How do we pick them? Fundamental analysis. We look first at operating cash flow versus the total dividend a company could pay. Can it cover its fixed obligations (debt) easily and still pay a dividend? If so, how generous without crimping re-investment. Reinvestment is the key to generating growth. You get that compounding effect from a high return on equity, which builds value exponentially. While that is happening you’re also getting income.

 

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About the author
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Richard Hemming , Under the Radar Report

Richard is an experienced finance analyst, stockbroker and financial journalist, having worked for over 25 years in the finance sector. He has worked as an analyst and stockbroker in Sydney and in London and for the Australian Financial Review, Investors Chronicle and the Financial Times. He had always wanted to start a research newsletter focussed purely on Small Caps because they were simply not covered with any regularity by stockbrokers because they were too small. Small Caps require diligent research and follow up. The lack of quality research on Small Caps was why Richard started Under the Radar Report with Caroline Mark.

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Richard Hemming

Under the Radar Report

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