How to get dividends while investing for growth

Takeovers are ramping up after a Covid induced hiatus. Money is cheap, big companies are looking for growth and private equity is looking to make money. You might have heard about Macquarie’s MIRA taking over waste management company Bingo for $2.6bn, the attempted takeover of fund administrator Link Administration by high profile private equity funds Pacific Equity and The Carlyle Group, Blackstone’s bid for Crown Resorts or Coke Europe bidding for the ASX listed bottler Coca-Cola Amatil.
 
The country’s bankers are turning their attention away from IPOs and onto M&A. In the past 12 months in Australia, for deals over $100m, there have been 80 worth $83bn and the vast majority have been at the Small Cap end of the market. Only 20 of the deals were valued at over $1bn. These 60 deals are the ones you might not have heard of.
 
In our universe there has been the takeover of IT services group RXP Services for a 62% premium by Capgemini; we’ve also had ongoing takeover dramas from private equity interest in troubled beauty products wholesaler McPherson’s (MCP) and aluminium products manufacturer Capral (CAA).

What has this got to do with dividends, you rightly ask. Acquirers are interested in companies producing good cash flow, which is what investors should be interested in; especially in this situation because it underpins the dividend. The bottom line is it’s a good discipline to look for dividends.

Under the Radar Report's Dividend Portfolios: Outstanding Performance

Over the past 4 years we have published a couple of dividend portfolios each year, selected exclusively from our small cap stock universe. We’ve just put another together. How have we gone?

Our average return is just under 20% versus the S&P/ASX All Ords Accumulation Index return of just under 6%.

Share price rises after takeover offers

These portfolios have often benefited from corporate activity. There are always bidders looking at stocks with quality businesses at the small end of town.
 
The latest portfolios benefited from a takeover bid for Capral (CAA), which propelled the stock up over 30% before settling back. Small Caps that make a takeover can also perform well because their adding value to a smaller asset base. For instance, Hansen Technologies (HSN) has been reaping the rewards of its Sigma acquisition in 2019.
 
Sometimes a company that we include in a dividend portfolio doesn’t end up paying one, which can end up being a blessing. A recent example is Alliance Aviation (AQZ) which instead chose to raise funds for a major capacity expansion and to conserve its cash. The market loved the expansion plans, and the stock has performed very well. 
 
The company’s ability to generate sustainable and growing earnings paid off. Even though AQZ didn’t pay a dividend, the capital it raised was for growth, and the stock jumped.
 
How do we pick them? Fundamental analysis. We look first at operating cash flow versus the total dividend a company could pay. Can it cover its fixed obligations (debt) easily and still pay a dividend? If so, how generous without crimping re-investment. Reinvestment is the key to generating growth. You get that compounding effect from a high return on equity, which builds value exponentially. While that is happening you’re also getting income.

Here are three Small Caps that have delivered strong dividends over the long term and also look good value:

Small Cap: MACA 

The mining services company is a consistent dividend payer partly because it has size in a cyclical industry, as the largest contractor in WA. MLD contracts in small and large open pit mining; as well it diversifies in crushing, civil construction and infrastructure maintenance. Reflecting its scale, the company has annual revenues of $1.2bn, work in hand of $3.4bn and a $4.2bn pipeline of opportunities to convert. MLD is on track for record earnings in FY21.

Small Cap: MYSTATE

The Tasmanian financial services group is benefiting from a growing deposit base, reduced costs and a move into funds management. Diversifying its earnings base is important because MyState is a big player in a small market on the lending front. The bank has a strong capital backing with CET1 (core) equity of 11.2% and will not shoot the lights out on the growth front, but we believe that its 5.6% dividend yield will grow to about 6% over the succeeding years and is well underpinned by its asset base and market position.

Small Cap: GALE PACIFIC

Our patience with the shade cloth manufacturer is paying handsome dividends as US sales and distribution grows. The company still looks good value, trading on a one year forward PE of just over 10 times and we forecast an annual dividend of 2 cents.GAP’s earnings are cyclical, but it had the operating cashflow to pay a special 1 cent interim dividend.It’s not a screaming buy at current levels but its dividend yield should deliver a good cash return at current prices.

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