Nine high-yield small-cap shares

It has been a truly shocking 12 months for equity income investors. For example, the negative 1.4 per cent total return from the MSCI World High Yield index compares with a positive 12 per cent from the MSCI World index. Life has been harder still for income investors in the left-behind UK market. 

In keeping with this dire run, my high-yield small-cap screen has underperformed for the first time since I started to monitor it eight years ago. It was not that last year’s picks didn’t include some big winners, it's just that there were a lot of ghastly losers, too.  

12-month performance

Source: Thomson Datastream

The pandemic and lockdowns have tested the central argument for investing in income stocks; that solid long-term dividend records can help identify companies with reliable businesses and strong balance sheets. 

Many of the high-profile blue-chips that have made cuts during the crisis actually looked like they were pursuing fantasy dividend policies long before Covid-19 struck. But for others, the rug has been pulled from under previously viable dividend policies. Many of these companies should ultimately get back on track as trading conditions begin to normalise, but it could be a long haul.

However, those companies that have continued to pay out arguably deserve special attention now. Companies that have surplus cash to return to shareholders even during a severe crisis set themselves apart as potentially having very reliable businesses. And in the case of smaller companies, which are often less mature than larger peers, there is also often more potential for growth as well as income. 

My high-yield small-cap screen attempts to hone in on the shares of companies for which a strong dividend record may be a sign that their underlying operations have genuine merits. The screen does this by looking for indications of earnings growth, a strong balance sheet and good dividend cover. The criteria are:

■ A historic and next-12-month forecast dividend yield among the top half of all dividend-paying stocks screened (see below for changes to this criteria).

■ Dividend cover of 1.5 times or more.

■ Three-year dividend compound average growth rate (CAGR) of 5 per cent or more.

■ Three-year EPS CAGR of 5 per cent or more.

■ Average forecast growth for the next two financial years of 5 per cent or more.

■ Interest cover of five times or more.

■ Positive free cash flow.

Up until this year, the screen’s stock selections had outperformed every year. That means even after a poor 12 months the eight-year cumulative total return of 191 per cent is well ahead of the 90 per cent from the market (a 50:50 split of the FTSE Small Cap and Aim, reflecting the indices screened). The screens are intended as sources of ideas for further research rather than off-the-shelf portfolios, but if we inject a bit of reality into the performance figures with a notional 2.5 per cent annual dealing charge (I’ve set this high to reflect the fact spreads can be high on illiquid small-cap shares) the total return drops to 138 per cent. 

Source: Thomson Datastream

Recent events have not only been testing for this screen in performance terms. I’ve found the screening criteria used in previous years too testing to generate any positive results. I’ve therefore relaxed the screening rules about dividend yield to allow shares with a better than median average yield (historically and forecast) to pass. This replaces the old rule that required yields to be in the top third of all stocks screened. Even after this change, only two shares passed all the screen’s tests. I’ve therefore included in the results shares that passed the softened dividend yield test but failed on one of the other criteria.

I’ve taken a brief look at the three highest yielding shares in the table. For my money, only one of them makes a part-way decent proposition based on what the screen is looking for.

9 high-yield small-caps

Source: FactSet

STM

Financial services group STM (STM) has been limping along ever since warning on profits about a year ago. Slower than expected new business wins and issues with the integration of a pensions services acquisition have weighed on performance, and a hike in professional indemnity insurance premiums has also squeezed margins. Indeed, first-half underlying profit margins were down from 20 per cent to 16 per cent. Receivables (income recorded but not paid) were also up in the first half.

While the company passes most of the screen’s tests, it fails on historical dividend growth. This reflects the fact it scaled back its final payment last year due to the disappointing trading. This year’s interim payment also reflected the rebasing, dropping from 0.75p to 0.55p. 

The question is whether there are reasons to put hope in the dividend being held from here and in trading improving. Supporting the payout is the company’s £17.6m net cash position. However, this money needs to be seen in the context of the company’s multi-jurisdictional business, which requires it to hold funds to support regulatory and solvency rules..

High levels of recurring revenue is a positive. The company reckons about 85 per cent of turnover is recurring. Its core pensions business, which accounts for 67 per cent of sales, is a strong contributor to recurring work. 

Management has also continued to insist that despite slow progress recently, it should see increased sales from new products and business wins. While the company has recently pointed to Covid for delays, progress had slowed before the pandemic. That said, the final quarter of the year tends to be the strongest for the group. With the valuation implying expectations are very low, there could be significantly more to gain here from good news than there is to lose from further bad news. 

Acquisitions could ignite some excitement, too, with the company this month announcing a £5.5m deal facility with RBS. The travails of lockdown may have produced some good opportunities.

This may hold some attractions for bold contrarians with the cash position offering some reassurance. However, priced at six times forecast earnings and yielding over 6 per cent, the shares have a classic run-for-the-hills valuation.

Pan African Resources

A more than fivefold increase in Pan African Resources' (PAF) dividend underlined the strength of trading for the South African gold miner in the year to the end of June. Despite the challenges of Covid, the group managed to beat its 176,000 oz of gold production target, producing nearly 180,000 oz. With the help of the strong gold price and tight cost controls, headline earnings rose 93 per cent to $44.2m.

The dividend payout was actually in excess of its policy of paying out 40 per cent of earnings. 

There are reasons to hope things can get better, too. Gold price hedges were at a high level last year, but should now drop off, meaning it should benefit more from the high gold price. The company also expects to produce more gold with guidance of 190,000 oz for the year. 

There could also be some encouragement from development of the Egoli gold mine. The company reckons it could achieve an internal rate of return on the project of over 50 per cent based on a gold price of $1,650 an oz compared with today’s price of $1,870.

However, as with all gold miners, Pan Afrcan cannot offer the kind of stability this screen sets out to find. As with all miners cash flows and profits are very sensitive to the gold price given a high level of fixed costs. So whatever the merits of the shares, they’re not the greatest fit with this particular screen’s objectives. 

Polar Capital Holdings

Polar Capital (POLR) looks the most credible dividend play out of the three companies. That said, as an asset manager it can’t boast the type of really reliable and steady growth that this screen wants. Nevertheless, for a company in a sector that can always be expected to be buffeted by stock market sentiment, it has things going for it.

Active managers have been losing the battle with their passive counterparts for many years, which has left many struggling for a raison d’etre. Fortunately, Polar has something to offer based on the fact that its business is concentrated on niche areas, and particularly its leading tech-focused funds. 

Fund managers are always sensitive to market movements because, while much of their cost base is fixed, they generate income based on the amount of money they manage, which can fluctuate wildly due to market volatility and investors moving money. For Polar, the story recently has been a positive one, with markets recovering sharply since the March lows and its funds experiencing several months of net inflows.

Importantly, the recent net inflows have not been solely focused on its tech specialism, although these have accounted for a little over half the total in the first nine months of the financial year. The company’s specialist emerging market and biotech funds have also been garnering interest from investors. Having a good spread of specialisms is important given the vulnerability of each one to any major changes in trends.

Recent half-year results came in ahead of expectations, including the 9p interim dividend. The group’s surplus capital of 74p a share – based on calculations from broker Numis – is enough to support the dividend for the next two years. The company is also on track to do well from performance fees this year.

There is the possibility the shares could also re-rate if net inflows continue and momentum continues to build around non-tech specialisms.