Three high-yield small-caps

That said, the fact this screen has outperformed every year since I started running it in late 2012 strikes me as being an anomaly rather than a testament to the strategy’s infallibility. While I can’t predict when the run will end, it will end at some point. Still, it was an impressive showing last year, with only one share running into real trouble: insurance services company Redde (REDD).

2018 performance

Year-on-year performance

Source: Thomson Datastream

The cumulative effect of the seven years of outperformance is a 217 per cent total return from the screen, compared with 72 per cent from the market (a 50:50 split of the FTSE Aim All-Share and FTSE SmallCap). The cumulative total return only tells part of the story, though, as small-cap shares can be expensive to deal in. While the shares highlighted by the screen are only considered as ideas for further research rather than an off-the-shelf portfolio, if I factor in a fulsome 2.5 per cent annual charge to represent dealing costs, the total return drops to 166 per cent.

One of the key attractions of targeting small-cap dividend plays is that there is the potential to tap into both a high yield and the prospect of strong dividend growth. The criteria used by the screen attempt to capture the characteristics that such a stock may display. That said, while the principal dividend yield (DY) test is demanding, the other tests are not too exacting. What’s more, the test used based on forecast earnings growth needs to be seen in light of the low-quality broker forecasts for many smaller company shares. This reflects both limited broker coverage and the general unpredictability of trading for smaller companies. The full screening criteria are:

■ A dividend yield in the top third of all dividend-paying stocks screened.

■ 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.

This year, only three companies passed all the screen’s tests – these are the three shares listed at the top of the accompanying table ordered by highest to lowest yield. To bulk out the results, I’ve resorted to the same tactic I used last year, which allows shares to fail one of the screen’s tests as long as it is not the test for a high DY. A number of the shares highlighted have been the subject of noteworthy forecast earnings downgrades over recent months, which is a potential threat to the dividend. 

I’ve taken a look at the highest yielding of the three shares that met all the screening criteria. It offers some decent attractions for income-seekers, but is not without risk.

High-yield small-caps

Source: S&P CapitalIQ

The Property Franchise Group

For a second year in a row, The Property Franchise Group (TFPG) is one of only three shares to pass all the high-yield small-cap screen’s tests. It’s also the highest yielding of the three fully qualifying shares. 

The company owns and franchises six estate agency brands. Franchisees operating its traditional high-street brands, which include the likes of Martin & Co and Ellis & Co, pay fees equal to 9 per cent of revenue. Meanwhile, EweMove, an online hybrid business acquired for £9m in 2016, charges franchisees a monthly licence fee of £1,000 plus £250 per completed letting or sale. These management service fees (MSF) account for about 85 per cent of revenue. About 70 per cent of MSF comes from more economically-resilient lettings business and the rest from house sales. The group generates the other 15 per cent of sales from a very small financial services operation, the sale of franchises, and additional franchisee services.

The company has certainly established an impressive dividend record since floating on Aim in 2013. From its first full year as a listed company in 2014 to the end of 2018, the dividend has more than doubled from 4p to 8.4p. The payment has been well covered by earnings and, more importantly, free cash flow (FCF). And management has stated it would like to get the dividend to 10p. The half-year payment was up 6 per cent.

The company’s fundamentals also display the attractive qualities that are often associated with a franchise business: high returns on capital and excellent cash generation (see chart). Successful franchises boast such attributes because franchisees tend to finance most of the investment needed to fund growth. That said, the kind of brand strength needed to build a really successful franchise business is hard to come by in the competitive and cyclical world of estate agents. As well as other franchise-only estate agency businesses, such as listed players WM Winkworth and Belvoir, large estate agency chains are also pushing into this part of the market, for example LSL, which is six times Franchise Property Group’s size by market cap. 

There are also some major industry-wide challenges – albeit challenges that may also bring long-term opportunity. In Franchise Property Group’s most important market, lettings, both its franchisees and landlords face tough new regulations. 

Midway through this year, a law came into effect banning agents from charging tenant fees. Property Franchise Group estimates that these fees have historically accounted for 16 per cent of its franchisees’ revenues. Meanwhile, a trend towards renting properties for longer periods, while offering more stability, has reduced opportunities to raise rents and win new business when contracts come up for renewal. Higher regulatory standards are also being heaped on landlords and a cut to mortgage interest tax relief is hurting. This has made for a subdued buy-to-let market and a rising landlord attrition rate.

Commission revenue from property sales is also under pressure. Having been flat for several years, property transaction volumes have recently fallen as Brexit uncertainty has mounted.

In all, over the next three to five years Property Franchise Group reckons industry pressures could see a 20 per cent reduction in the number of estate agents in the UK. On the face of it this sounds like bad news for the company’s prospects, but there are some reasons for optimism. 

Firstly, Franchise Property Group has taken a proactive stance against the problems faced by its franchisees. The group does expect more traditional franchisees to shut up shop, and the number of such offices fell from 283 to 259 in 2018 and franchisee recruitment was down 30 per cent. Nevertheless, properties under management – the key revenue driver – has continued to grow, up 6 per cent to 56,000 at the half-year stage. 

The company has also formulated a tenant-fee mitigation plan for its franchisees (raising management charges and rents), which it expects to fully compensate for lost revenues by the end of next year. In fact, in July, the first month after the ban, there was actually an uptick in management service fees as agents moved to new arrangements with landlords to compensate for the rule change.

The added regulatory pressure on landlords may also cause more of them to seek the services of a reputable agent offering a fully managed service. Only about 15 per cent of rental properties are currently managed by agents, so there is much to play for. What’s more, rising regulation and higher professional standards have the potential to create some barriers to entry.

Meanwhile, the expected failure of weaker rival agents should create opportunities for Property Franchise Group’s franchisees to win new business. To this end, the company is offering market intelligence, advice and financial support to franchisees that want to buy managed property business from rivals. There were 17 acquisitions made in the first six months of 2019, which the company provided £0.1m of assistance with. Financial assistance is treated as an investment (ie recorded on the balance sheet to be amortised rather than being taken as a cost against income) so acts as a dampener on cash conversion, but at the moment the level of spending is not an issue of note.

Management has also said it thinks there could be acquisition opportunities in the next 12 months, which would allow it to put the group’s healthy balance sheet to use. 

The company has two other potentially exciting growth opportunities. One is through its hybrid online business EweMove, acquired in 2016. Online estate agents have been growing fast, increasing market share from 3.4 per cent in 2016 to 7.2 per cent in 2018, according to research firm Statista. EweMove stands out from rivals by operating a 'no-sale, no-fee' model, in contrast to the controversial non-refundable fees charged by other online agents. The operation also has a strong focus on customer service levels and has held the top spot on TrustPilot since 2016, which helps it to recruit both property listings and new franchisees. The expertise of EweMove is also being used to boost the web presence of the traditional brands and improve the efficiency of online marketing. EweMove’s first-half managed service fee contribution was up 15 per cent to £1.1m, representing almost a quarter of total fees.

The other noteworthy growth opportunity is in financial services. The company only generates 1 per cent of sales here, which is paltry by the standards of rivals; LSL generates 27 per cent of revenue from financial services income. The company has now found a potential partner that would allow it to work closely with franchisees and incentivises them to promote financial services sales. It is hoped more details will be forthcoming early next year. In the meantime, the group has said growth from this area would not require any significant capital.

The chief challenge is for the company to continue to make headway despite current industry challenges. But there is a plausible case that, with the right support, franchisees may emerge from this period of regulatory change stronger. On this front, it is encouraging that the number of franchises available for resale at the half-year stage was among the lowest on record, suggesting on-the-ground agents have some confidence. Meanwhile, online and financial services could provide genuine growth opportunities. And while small-cap broker forecasts are notoriously unreliable, it is noteworthy the one broker that does provide forecasts for the group – the house broker – significantly upgraded predictions following the interim results.

All in all, the shares look an attractive, albeit risky, small-cap dividend play. The low valuation, robust balance sheet and strong cash generation all provide reassurances.