3 Small Caps With Major Dividend Potential

If you feel like you're falling behind financially, you're not alone. Frugality and a healthy household balance sheet may help some of us sleep better at night, but the returns on savings accounts are so low, they're practically negative in real terms -- depending on which inflation measure you like to use.

It's no wonder, then, that dividend-paying stocks have returned to darling status lately. Yields as low as 2% provide a huge bump up in what your spare money pays out. Although stocks are much riskier than cash in the bank, investor memory is short, and the last year's market rally remains fresh in many people's minds. Though you and I know that stocks aren't a no-lose proposition, they certainly seemed that way until the market turmoil of the past few weeks. If you can achieve both capital gains and a cash payout, why wouldn't you take advantage?

Then and now
I've been called crazy before for suggesting Fools buy anything now. With market pundits continually calling stocks "overvalued" by indexwide price-to-earnings metrics, and major uncertainty in energy, it might seem like a bad time to go dividend-hunting. But I've never much cared for wide-view market punditry; I prefer to concentrate on individual opportunities. Even in the fluffiest of markets, investors are always discounting certain stocks' potential. I'll share three of the better ideas I see right now, and tell you why they catch my eye.

For me, yield isn't the only thing to consider when looking at a dividend payer. I'm looking for long-term holds and a great likelihood of a growing dividend over that period. Growing dividends demand growing companies. That's why I'm not interested in securities like the high-yielding BP Prudhoe Bay Royalty Trust (NYSE: BPT  ) , which earns a straight royalty on a slice of oil production in Alaska, and is thus more or less a direct bet on oil prices.

Here's what I look for:

A business with plenty of room to grow
The easiest way to find these is to screen stocks by market cap. As the co-advisor of Motley Fool Hidden Gems, I usually restrict my digging to companies between $250 million and $2.5 billion, but when I'm looking for dividend payers that still have plenty of room to grow, I'm happy to consider companies up to $5 billion "small." However, that's as big as I go when I'm looking for this kind of dividend payer.

Why? Huge companies have often exhausted much of their growth potential. A company that can double or triple in value over the next five years, and increase its dividend along the way, is much more likely to pay me two ways, with capital gains and an expanding dividend.

That's why I'm often lukewarm on buying even a great company like Altria Group (NYSE: MO  ) . The nice 6% yield comes with lackluster, low single-digit revenue growth, which I don't think is likely to change much, given Altria's already-dominant market position.

A business with a proven record of growth and profitability
The recent recession makes gauging growth a bit tough, but in general, I like to see the top line growing at least 10% per year over a rolling three- to five-year period. It should (but doesn't) go without saying that I want to see an increase in profits as well -- and not just net profits. I want to see free cash flow (FCF), which I define as cash from operations less capital expenditures, steadily increasing as well. Corning (NYSE: GLW  ) , which has grown both net income and FCF at a compound annual growth rate of more than 40% a year over the past five years, would fit the bill nicely, if it didn't already command a $33 billion market cap.

Dividend coverage
I like to see a company covering its dividend with cash produced from operations. I know that with interest rates as low as they are, many companies are bulking up on debt, and some of them are using that debt to pay dividends. While I understand the arguments for doing so, it's not an approach I like for the long term. I prefer companies that are committed to paying as they go, not only because it avoids balance-sheet uncertainty, but also because I like the fiscal conservatism that underlies such a decision.

I grew up watching wrestling, but my love of body slams and sleeper holds can't keep me from throwing World Wrestling Entertainment (NYSE: WWE  ) over the top rope. (We'll forgo the folding chair to the back of the head for now.) The flat top-line is bad enough, but the current 12% yield comes on the back of payouts that roughly double the company's cash from operations. That suggests to me that those dividends are likely to drop significantly in the not-so-distant future.

The ones to watch
I've watched Healthcare Services Group (Nasdaq: HCSG  ) for quite a while, and unfortunately, never had the guts to buy. (The stock is up about 20-fold over the past decade, including dividends.) It's a small provider of linens, housekeeping, food, and related services to nursing homes, retirement centers and hospitals. That seems like a small-moat business, and the stock always looks expensive, but the results say otherwise. Healthcare Services has grown the top line better than 10% per year for the past decade, and grown earnings and FCF at an even faster clip. It currently yields 3.6%, and it has increased its dividend payments (significantly) every year since 2003. I also happen to think it's got a great position in the health-care market, no matter what you expect of our recent health-care legislation. With Boomers getting older, it's hard to imagine any scenario under which health-care sanitation services see a big drop in demand.

Guess? (NYSE: GES  ) has always had trouble getting Mr. Market's respect, even though it has given investors a decade's worth of mid-teens (and better) revenue growth. Over the past few years, Guess? has taken more control of its brand away from other retailers on which it formerly relied, opening its own retail stores in the U.S., and more recently expanding its footprint in Europe and Asia, where it now generates its greatest growth. Even after funding that expansion, the company throws off plenty of spare cash, which it has used to buy back shares and pay a dividend. Thanks to the market's disappointment with next year's guidance (mere 15%-ish earnings growth), the stock dropped, and it currently yields a modest 2.1%. However, that dividend has been steadily increasing. With its history of besting estimates, my best guess is that the stock rebounds to reflect the company's growing prospects, and investors harvest a nice cash payout along the way. That's one of the reasons why I own it personally, and why we own it at Hidden Gems.

Grupo Aeroportuario del Sureste (NYSE: ASR  ) may be the spiciest of the bunch. This Mexican airport operator (known as ASUR) enjoys monopoly positions in running nine airports, with the vast majority of revenue and earnings coming from the Cancun airport. While Mexico remains one of the world's biggest travel destinations, suffering consumers mean lost potential for the vacation business. Cancun's traffic has held up unexpectedly well given the state of the U.S. economy, and even media reports of horrific drug violence in Mexico haven't blunted traffic much. That, of course, might change. Another risk of unknown impact is the upcoming construction of a new airport to serve the Mayan Riviera -- traffic that is currently routed through Cancun. So far, ASUR has been frozen out of the contenders to operate that airport. If you believe, as I do, that there will be enough future business for both airports, you should keep an eye on this 3.7% yielder.

Foolish final thoughts
There's no one way to invest, and investors interested in income from their stocks don't have to settle for giant, stagnant cash producers. If you're not ready to add any of these to your portfolio, consider adding them to My Watchlist, our free service that lets you keep track of the story, and provides personalized news updates on the stocks you care about most. And let me know what your favorite small-cap dividend payers are in the comments below.

Grupo Aeroportuario Del Sureste is a Motley Fool Hidden Gems recommendation. Motley Fool Options has recommended a modified stock repair position on Guess?, which involves owning the stock and buying and writing various call options. The Fool owns shares of Altria Group and Guess?.

At the time of publication, Seth Jayson owned shares of Guess? but had no position in any other company mentioned here. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (58)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 28, 2011, at 1:08 PM, JB0105 wrote:

    You like HCSG but did not address the issue of their unsustainable payout ratio. Comment?

  • Report this Comment On March 28, 2011, at 2:25 PM, Stocklovr wrote:

    HCSG: Huge Payout Ratio (TTM):117.00 % vs.

    Industry: 16.00 %

    I owned this stock for a couple of years but the payout ratio really bothered me so I sold.

    Eventually, a company cannot keep paying out more than it earns unless they are organized like a REIT.

    In addition to the payout ratio, everything about this stock yells "expensive".

  • Report this Comment On March 28, 2011, at 10:22 PM, imakecoffee wrote:

    So, any idea WHO are the contenders for the new airport?

  • Report this Comment On March 29, 2011, at 10:18 AM, TMFBent wrote:

    Over the past 5 years, HCSG has paid out less in dividends than it has produced in FCF. That may change in any given year, but unless the policy is to consistently overpay, then the dividend looks safe enough to me.

    Sj

  • Report this Comment On March 29, 2011, at 3:10 PM, mikecart1 wrote:

    Author is obviously unaware that the Rock has returned to WWE and Wrestlemania is expected to be the biggest in years.

  • Report this Comment On March 30, 2011, at 3:43 PM, Stocklovr wrote:

    I owned the stock for several years. Their dividend payout - through the entire time I owned it - was over 100%.

    I did not want to sell the stock but I was extremely uncomfortable with this policy. In addition, they have raised their dividend every single quarter for at least the last six years. Normally, this is something that I would love if it weren't the extremely high payout ratio.

    How does one justify FCF versus earnings? If this were a REIT, I'd understand that earnings are skewed due to depreciation, etc. Since it is not, don't you need to look at earnings more closely than FCF?

    I'd really like to know how to square this difference.

  • Report this Comment On April 01, 2011, at 10:15 AM, dgmennie wrote:

    Why has THE FOOL just recently eliminated the reader comments section from its "headlineof the day" and "today's watchlist" articles?

  • Report this Comment On April 02, 2011, at 8:39 AM, lqs101 wrote:

    how do you determine how much wwe is paying in dividends (the total, not the percentage), in order to compare that figure to its cash from operations?

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