Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which smaller companies in the asset management industry offer the most promising dividends. (Last time I looked at this industry, I took a broader view and ended up focusing on larger players. Each of these has a market cap between $200 million and $4 billion.)

Yields and growth rates and payout ratios, oh my!
Before we get to the companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

  1. The current yield
  2. The dividend growth
  3. The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into asset management
Below, I've compiled some of the smaller dividend-paying players in the asset management industry, ranked according to their dividend yields:

Company

Recent Yield

5-Year Avg. Annual Div. Growth Rate

Payout Ratio

Add to Watchlist

 

BlackRock Kelso Capital (NYSE: BKCC) 12.2% (9.3%)* 112% Add
Walter Investment Management (AMEX: WAC) 11.2% (41.8%) 145% Add
Prospect Capital (Nasdaq: PSEC) 10.0% 6.6% 80% Add
MCG Capital 9.1% (18.6%) NM Add
PennantPark Investment (Nasdaq: PNNT) 8.8% 7.1%* 111% Add
TICC Capital (Nasdaq: TICC) 8.5% (2.3%) 41% Add
AllianceBernstein 7.6% (16.1%) 114% Add
KKR Financial Holdings (NYSE: KFN) 5.9% (25.1%) 18% Add
Westwood Holdings 3.7% 2.0% 99% Add
Federated Investors 3.7% 31.0% 128% Add
Duff & Phelps 2.1% New dividend 38% Add
Waddell & Reed Financial 2.0% 6.1% 42% Add
Epoch Investment Partners 1.4% 33.9%* 113% Add
Cohen & Steers 1.9% 20.5% 224% Add

Data: Motley Fool CAPS.
NM = Not meaningful due to negative earnings.
*Over past three years.

If you focus on dividend yield alone, there are plenty of companies here with exceptional payouts. But many of them have high payout ratios, and several have seen their dividends actually fall over the past five years.

Instead, let's focus on the dividend growth rate first, where Federated Investors and Cohen & Steers lead the way. Their growth rates are so steep, though, that they may be hard to maintain for long. And the fact that their payout ratios exceed 100% is also a red flag.

You may notice, too, that some familiar players in the industry aren't on the list, such as American Capital (Nasdaq: ACAS). Many smaller companies don't yet pay dividends, preferring to plow any excess cash into operations or growth. American Capital actually did pay a dividend until recently, suspending it in 2008. Don't be surprised if it reappears at some point.

Just right
As I see it, among the companies above, Prospect Capital has the best combination of dividend traits, sporting a hefty yield, a serviceable dividend growth rate, and a fairly reasonable payout ratio. It offers solid income now and a chance of strong dividend growth in the future. Don't dismiss the rest of the bunch, though -- the financial industry has been through the wringer lately, and many of these firms will be getting stronger and probably hiking their payouts.

Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers. 

To get more ideas for great dividend-paying stocks, read about "13 High-Yielding Stocks to Buy Today."

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Federated Investors is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.