We have recommended 10 Small Cap Dividend Portfolios over the past 5 years. One or two stocks in the first 8 portfolios have returned more than 100% delivering outstanding portfolio returns to our subscribers. The most recent two portfolios: give them time!

How do we pick these stellar stocks? Here are 5 fundamental principles we use to pick out a Small Cap Dividend success.

Read more about Investing in Small Caps. Why we picked these ASX Small Cap gems and their outstanding performance.

1. Operating Cash Flow Versus the Total Dividend

The first thing Under the Radar looks for is that the business can sustainably generate enough cash to ensure that it can pay dividends. We look at the volatility of operating cash flow over time. Earnings before interest, tax, depreciation, and amortisation (EBITDA) often approximates operating cash flow, so we look at ratios involving this metric. We also look at how many times the dividend is covered by earnings (called dividend cover). The more, the better!

We also look at the net debt multiple, or net debt (debt minus cash) divided by EBITDA. If this multiple is high, the company’s liabilities and earnings profile may be at risk. Possibly a better ratio is interest cover, which is EBITDA divided by net interest (interest paid minus interest received) because this includes both flow concepts.

A stock like the crane services provider Boom Logistics (BOL) has a dividend yield of almost 9% but is a very capital intensive operation. The company is currently producing strong cash flow but there are huge risks on the labour front. You don’t want to be picking up dividend pennies and then get rolled by a steam roller in the form of an unexpected profit warning. Although we like BOL at current prices we wouldn’t put it in a dividend portfolio.

The headline yield isn’t everything and Under the Radar’s analysts look at the sustainability of dividends.

October 2020 Dividend Portfolio: 30.5% return

The most recent two portfolios from October 2020 and April 2021 are yet to get a stock with a 100% return but give them time! They have still returned 30%!

2. Net Debt, Duration and Assets

These metrics cover balance sheet issues that may arise. The balance sheet is simply a snapshot of the company’s assets and liabilities at one point in time. However, it is necessary to analyse the make up of those assets and the duration of the loans granted to the company. Assets can be tangible, such as property and plant equipment, and intangible, such as intellectual property and goodwill. Intangible assets can evaporate quickly, which could cause a capital raising. Tangible assets can be stranded, meaning they are unproductive, and be written off completely.

3. Industry and Sector Factors

Some sectors have high working capital requirements. These include manufacturing, where material and labour are needed to produce widgets. The capital requirements of the business vary greatly at different times in the business cycle. We picked aluminium products maker Capral (CAA) last year and the company has surfed the increasing barriers to trade that have inevitably occurred through Covid.

Companies that have strong balance sheets and cash flow are desirable for investors both big and small.

4. Dividend Growth Potential

Here the dividend cover is important. Under the Radar looks for companies that re-invest earnings and achieve a high return on equity. This generates that compounding effect that can supercharge a Small Cap’s earnings and hence dividend growth. We’re also looking for strong free cash flow for the same reason. This refers to operating cash flow minus capital expenditure.

If you look closely at the contractors SRG Global (SRG), Maca (MLD), GR Engineering (GNG), and Southern Cross Electrical (SXE) they all have very strong balance sheets and taking take advantage of growing commodities demand, but more importantly increasing big infrastructure and construction projects. In the past few years, these companies have diversified their operations and increased their exposure to annuity income.

5. Special Circumstances

A good example in our past portfolios has been the paper and print group Spicers (SRS) but this has been taken over. Alliance Aviation (AQZ) was identified because of its strong balance sheet and instead of paying dividends, it made a prudent investment. Its shares have taken off.

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