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3 Dividend Paying Small Caps To Protect Your Portfolio From Volatility

Richard Hemming

Dividends really do reduce a portfolio’s volatility. Day to day gyrations don’t matter if you are receiving a half way decent interim and full year dividend. Watch the company, don’t watch the market.

WHY AUSTRALIANS LOVE DIVIDENDS

If you want evidence that dividends reduce volatility, just look at the Australian market, whose average forecast dividend yield is 5.1 per cent (excluding franking), which is double the average for the US market, which is closer to 2.5 per cent on the S&P 500 Index. The tech heavy Nasdaq Index will be even lower. The sell off in the fourth quarter of 2018 was much more aggressive in the US market, where the S&P/500 fell 14.0 per cent, compared with the ASX All Ordinaries decline of 9.7 per cent.

An image of Australian money

When you look at the paltry 2.4 per cent rate of return you get on a 12-month fixed term deposit, it’s no wonder Australian investors look to equities. But as you would no doubt know, an important reason is the franking credits that are often attached, which incentivise companies to return capital to shareholders via dividends. The corporate tax that a company is already obliged to pay can deliver a 40 per cent plus boost to dividends paid to a qualifying shareholder. This is effectively hidden value in a company because it doesn’t sit on the balance sheet and is only evidenced via a lowly note in the accounts.

The franking credit system was designed to stop double taxation and it is the cash refunds for excess dividend franking credits that the Australian Labor Party has stated it will move to stop if it gets into the government. Arguably, after Labor’s emphatic victory in the Victorian election late last year, the markets have priced this in.

THE BIGGER POINT IS NOT OVERPAYING FOR THOSE DIVIDENDS

What is much more important from the investor’s viewpoint is how much you pay for those dividends. Investors in the past have paid too much. Wait, let me put this another way because it is actually the companies that pay too much! Telstra is a classic example. The company paid out more dividends than its cash flow warranted, failing to invest in growth and to take into account the competition arising from the NBN. All the while it was eroding its balance sheet strength. Then the crunch came when the company could not maintain its fiction that profit margins were being sustained and it was forced to reduce its dividend payout.

Which brings us to small caps. These companies generally have higher risk than their bigger counterparts, but because the universe on the ASX is so big, we are always able to find at least 10 companies that measure up to our dividend paying criteria: strong operating cash flow versus total dividend; moderate net debt when compared with duration of assets; and dividend growth potential.

MYSTATE (MYS)

We like both the regional banks we cover, but the Tasmanian based MyState is probably a safer bet because of Auswide Bank’s concentrated Queensland exposure. The company has proven to be a steady performer and provides ballast in the volatile small cap world, through the provision of modestly growing fully franked dividends supported by its strong capital position and pristine asset quality. At current levels the company trades on a fully franked dividend yield of over 6 per cent.

GALE PACIFIC (GAP)

The shade cloth maker’s earnings aren’t as consistent as MyState, but it’s 2 cents a year of dividends is, which puts it on a 6 per cent dividend yield. The company has exposure to changes in exchange rates and raw material prices and the vagaries of weather, yet trading on a PE of under 10 times, it’s good value. Moreover, the company has a strong core business, which sells into markets as diverse as the Middle East and the US. Growth is a big possibility and you get compensated in the mean time.

INGENIA COMMUNITIES (INA)

Long term readers of this column will know that Under the Radar has long been a fan of this retirement accommodation operator, whose yield is low compared to the other two at 3.6 per cent. What you get in return is a company with a recurring revenue stream and strong development pipeline supported by demand from retirees with a limited budget. In its innovative model, Ingenia offers accommodation based on either a land lease model where a person buys a home in an Ingenia community and rents the land on which the home sits on, or just rents the home.

About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

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