Join our community of smart investors

18 high-yield small-cap plays

After six straight years of market outperformance, can this year's 18 screen picks manage the same?
November 27, 2018

Smaller companies are not normally the first port of call for income hunters – that’s if they’re a port of call at all. A key reason the potential of smaller companies as dividend payers is often overlooked is that their businesses tend to be less robust than those of their larger peers. This increases the likelihood of dividend cuts when times get tough. Another factor is that income is not of primary importance for many smaller company investors. Often the allure of dabbling in small cap stocks is based on the potential to find tomorrows giants while they’re still minnows. Companies that fit this bill should be able to make far more lucrative use of their cash by investing in growth rather than handing it back to shareholders as dividends.

However, many smaller companies measure up very well as dividend payers. The fact that some dividend paying smaller companies are not very mature businesses means they can also offer better dividend growth potential than larger income plays. And small caps that are generating enough cash to underpin a decent dividend may prove less prone to blow up than racy small-cap growth plays, which can have very impressive profits but far less impressive cash flows.

At the moment, my high-yield small-cap stocks screen looks a great advert for this approach, given it has outperformed in each of the six years I’ve run it. However, it is worth stressing such consistent outperformance is something I would definitely not expect to continue. That’s not to besmirch the long-term arguments for small-cap income. It’s just the distinct nature of the strategy is not one that is likely to always deliver performance that is better than the wider market. And like almost all the screens run in this column, the assumption is the result presented here are primarily of interest as a source of ideas for further research rather than as an off-the-shelf portfolio.

Another consideration that may pour some cold water on the consistent annual outperformance of the screen over the past six years is the fact that the outperformance of the past 12 months was a skin-of-the-teeth affair. The seven stocks picked by the screen a year ago scraped in only just ahead (or rather less behind) a 50:50 split between the FTSE Small Cap and Aim All-Share indices with a negative total return of 6.4 per cent compared with the indices combined negative 6.7 per cent.

2017 performance

CompanyTIDMTotal Return (28 Nov 2017 - 23 Nov 2018)
RMRM.23%
T ClarkeCTO22%
SandersonSND21%
Telford HomesTEF-21%
AlumascALU-22%
RecordREC-31%
Photo-Me Int.PHTM-36%
FTSE Small Cap--4.1%
FTES Aim All Share--9.2%
FTSE Small/Aim--6.7%
High Yield Small Caps--6.4%

Source: Thomson Datastream

The cumulative six-year total return from the screen now stands at 182 per cent compared with 71 per cent from the Small Cap/Aim index blend. However, that only tells part of the story as smaller company shares can be very expensive to deal in. To inject a sense of realism into the performance figures, I apply a hearty 2.5 per cent annual charge to the screen, which knocks the six-year total return down to 142 per cent (such a hefty charge provides a great illustration of how quickly dealing costs add up and why investors should do everything possible to minimise them).

 

The screen itself is conducted on all constituents of the FTSE Small Cap and Aim All-Share using the following criteria:

■ 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 stocks passed all the screen’s tests. I’ve therefore also included stocks that passed a weakened version of the screen which requires them to pass the high-yield test but allows them to fail one of the other tests. The stocks are ordered from highest to lowest yield in the table below, and where appropriate, details are given of the test failed. To give a flavour of the results I’ve also highlighted the two companies showing the highest three-year dividend growth, excluding the investment trust (Dunedin Enterprise) that tops all the screen’s picks based on this measure.

 

18 high-yield small-caps

CompanyTIDMMkt CapPriceFwd NTM PEDY3yr DPS CAGRFY EPS gr+1FY EPS gr+23-mth Fwd EPS chg3-mth momentumNet Cash/Debt(-)
Sirius Real Estate LSE:SRE£600m59p164.8%22%7.9%11%-28%4.2%-€323m
Walker GreenbankAIM:WGB£54m77p75.7%22%-26%-0.2%0.8%4.7%-£3m
Redde AIM:REDD£521m170p126.8%12%10%5.5%10%0.1%-£8m
BillingtonAIM:BILN£33m277p94.2%57%3.4%-0.4%-0.0%£6m
DFS FurnitureLSE:DFS£462m218p125.1%6.4%34%14%1.3%-0.9%-£160m
HeadlamLSE:HEAD£379m450p105.5%11%1.7%4.2%0.0%-1.8%£16m
Northern BearAIM:NTBR£14m76p-5.3%26%----2.4%-£1m
The Property Franchise GroupAIM:TPFG£35m134p105.6%20%9.4%2.7%--3.3%£1m
Target Healthcare REITLSE:THRL£420m109p186.0%1.8%12%13%--4.8%-£23m
Dunedin Income Growth Investment Trust LSE:DIG£354m239p-5.1%29%----5.5%-£63m
Highcroft Investments LSE:HCFT£47m905p-5.1%9.6%----6.2%-£14m
Dunedin Enterprise Investment Trust LSE:DNE£72m347p-5.5%59%----6.3%£0m
Best of the Best AIM:BOTB£25m243p215.6%*7.7%-11%---6.5%£2m
MJ GleesonLSE:GLE£362m664p114.8%47%7.7%10%0.4%-7.6%£41m
NorthgateLSE:NTG£486m370p104.8%6.9%9.1%13%0.0%-9.0%-£441m
Photo-Me InternationalLSE:PHTM£419m111p127.6%20%-2.3%8.0%0.2%-11%£25m
RotalaAIM:ROL£24m50p75.0%10%18%4.6%--12%-£33m
Central Asia MetalsAIM:CAML£361m211p77.8%7.6%37%0.7%--5.2%-$128m

*Includes special dividends

Source: S&P CapitalIQ

MJ Gleeson

The last five years have seen MJ Gleeson’s revenues more than double, earnings per share more than treble and dividend per share more than quintuple. But as the rating of the housebuilder’s shares suggest, there are grounds to wonder if this is as good as it gets. What’s more, given Gleeson’s business is cyclical, investors can expect a trough to follow any peak. But while there are good grounds think housebuilders may have already enjoyed the best of the current cycle, Gleeson’s business model may prove more resilient than those of rivals.

One of the key worries investors have about house builders prospect is the potential impact of the winding down of the Help-to-Buy government subsidy scheme. In some respects, Gleeson looks vulnerable with two thirds of its sales relying on Help to Buy. However, it has now been confirmed that the scheme will be extended to 2023 but restricted to first time buyers from 2021 and subject to regional price caps. The good news from Gleeson’s perspective is that almost nine-tenths of its sales are to first-time buyers and its focus on low-cost homes means its average selling prices are well below suggested Help-to-Buy price caps.

Its focus on building in the North East of England also means there is less to worry about regarding signs property-market wobbles in areas where housing affordability looks strained, such as London. Indeed, three of the five regions in which Gleeson operates have yet to see house prices recover to 2007 levels.

The company’s strategy of working with closely with local authorities to regenerate neglected land should also offer protection against land-price inflation. Indeed, Gleeson’s niche focus means it faces limited competition when bidding for plots and land costs currently represent only about 7 per cent of its average house selling price. And while other input costs are rising across the sector, Gleeson has a strong track record at keeping a tight rein on build cost, which should also help it protect margins.

While margins may look less vulnerable than those of other builders, it seems unlikely margins will rise from here following several years of expansion. It’s Gleeson’s sales that management hopes will be the key source of growth.  The company sees strong potential in its niche and is just over a year into a five-year plan to double annual production to 2,000 homes.

While the house building side of the business is where growth hopes are focused, stability is expected from the one third of profits that come from Gleeson’s land-banking operation. This business brings land through the planning system in order to sell on to other builders. This activity looks more exposed to the broader housing cycle, and has significant exposure to the South of England. However, with a well-stocked land bank of 61 sites, including 9 with consent, the division is aiming to keep profits stable at about the £12m mark.

Priced at 1.9 times tangible book value, Gleeson’s shares are not screamingly cheap compared with a full-cycle (12 year) average of 1.3. That said, the rating is some way off this June’s cycle high of 2.5 times. However, there is certainly an argument to be made that the company is being tarred with the same brush as its house builder peers when its model looks far better suited to the current environment, which means its dividends could prove more reliable.

 

Billington

Shares in Barnsley-based Billington, the UK’s third largest structural steel fabricator, boast some attractive credentials as a dividend play. Aside from the attractive historic dividend yield and mid-single digit forecast dividend growth, the attraction of the shares for income hunters lies in the company’s healthy cash position (£6m), the attractive and improving return it generates on capital employed (rising from less than 5 per cent to close to 20 per cent over five years) and a good track record at converting profits into cash (operating cash conversion has been well over 100 per cent in four of the last five years). That’s a lot of boxes ticked.

However, the relatively low rating attached to Billington’s shares reflects the inherent risks of a company in its line of work. Two key issues investors have recently had cause to consider are the cyclical nature of Billington’s end markets and fluctuations in raw-material prices.  

The construction sector has been in recovery mode since 2013 but faces uncertainties associated with Brexit and creeping worries about the global economic outlook. Billington is sensitive to the health of the UK construction industry and fell into a loss in 2012, although this was the only reported loss in the company’s 75-year history.

The risks associated with any downturn are increased by the fact that the company must manage large working capital items associated with the cost of work in progress on large complex steel structures, as well as payments to suppliers and from customers. Such balance sheet risks are familiar to investors in the construction sector. However, overall Billington’s short-term assets and liabilities net out to mean it has relatively low capital requirements compared with turnover (last year sales stood at more than three times average capital employed). Despite impressive growth in recent years, cash flow and capital turnover have benefited from falling working capital requirements, although, such advances are finite by nature and can reverse.   

Billington’s first-half trading gave some cause for angst. The collapse of Carillion had reverberations across the sector and Billington reported a slowdown in orders, especially in the first three months of the year, and reduced margins. This has left the company with ground to make up in the second half. The good news is that it seems to be doing exactly that.

While the order book was down on 2017 at the interim stage, it showed an encouraging rebound from the first quarter. Perhaps more significantly, last week the company reaffirmed expectations for the full-year whilst announcing three high-profile contract wins worth £41m. This was particularly encouraging because it followed comments from the company about large contract opportunities and one of the contracts is in Europe where Billington has been keen to build its presence.

Competition has been increasing in some of Billington’s markets and finding employees with the correct skills is tough. These factors, along with raw material price movements, contributed to the first-half margin drop. However, based on the company’s history, last year’s operating margin of just over 6 per cent does not look toppy. Indeed, while the 2009 peak operating margin of over 9 per looks something of an anomaly, a margin just shy of 7 per cent was achieved in each of the preceding two years. So there are grounds to hope profitability can continue to edge forward over the medium if end markets hold up although the company is now well out of its post-2012 recovery phase. For its part, management sees a positive outlook between 2019 and 2022 with demand still some way off the peak of the last cycle. The specialised nature of some of Billington’s work should also help support profitability, as should investments made to increase capacity and efficacy at its Shafton manufacturing site which was acquired in 2015.