A key takeout for Small Caps

A key takeout from our Dividend Portfolios over the past five years is the benefit of corporate activity. This is unlikely to occur at the big end of town.
Acquirers are interested in companies producing good cash flow, which is what we’re interested in; especially in this situation because it underpins the dividend. The bottom line is it’s a good discipline to look for dividends.

Going back we’ve 12 takeovers in the 9 portfolios

Our latest portfolios benefited from a takeover bid for Capral (CAA), which propelled the stock up 30% in the past week. Small Caps that make a takeover also benefit disproportionately because they’re benefiting a smaller asset base. Hansen Technologies (HSN) has been reaping the rewards of its Sigma acquisition in 2019, shortly after we first tipped the stock. 

Our portfolios have also benefited from fundamental research.

The June 2020 Portfolio was put together at a highly uncertain time with regard to payment of dividends.  Many interim dividends (for the period to 31 December 2019) had been cancelled or postponed, and COVID 19 shutdowns were in full force.
We are pleased that the vast majority (13/14) dividend companies did pay a dividend at least in line with our forecasts at the time.  The exception was 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.  AQZ has long been an Under the Radar Report favourite which some subscribers may still have at much lower prices.
The common denominator here is that our research about 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, not for staving off bankrupcy.

What do we look for?

We go through it in some detail in this issue, but to put it simply, 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.

Why do dividends matter?

In Australia our system is geared towards benefiting investors through franking credits accrued from dividends. Basically, the government is saying, we’ve taxed the company’s profits once and we’re not going to tax the individual stock holder.
This system benefits Australian generated profits over offshore.
Austal pays an unfranked dividend; while Capral has paid fully franked dividends at a fantastic yield. The franking credits boost the income received by a low tax paying investor by as much as 40% over the nominal dividend.
The key for investors is to work out how sustainable these dividends are at existing levels and even more important, whether they can grow along-side earnings.

A secret benefit of dividends

Averaging down doesn’t always work, especially when a company’s value is based solely on sentiment. Here you can be looking for the greater fool to take your money.
Sustainable dividends provide an investor with security because it means the asset base is producing profit growth.
When one or more of the stocks that you select falls in price, as long as the fundamentals remain intact, it is an even cheaper bargain.  Subject to your risk tolerance, you could get more stock cheaper. It is much easier to hold an investment that is delivering an income, even if the capital has gone down, than it is to hold a speculative investment in the hope that a greater fool will still want to buy it from you.

Diversification pays dividends

Both portfolios were sufficiently diversified, with 11 and 14 stocks each, but not so diversified that they could not outperform. There were no complete disasters which dragged the portfolio down. It only takes one really bad performer to overwhelm some good stock picks. 

 Of our 9 portfolios the only one that didn’t perform well had 8 stocks, of which 2 went backwards.

The key is to look for quality

If you are investing primarily for income, err on the side of caution in your selections.  Choose stocks with stronger balance sheets, like Austal (ASB) which although it was the worst performer in the June portfolio, paid its dividends as forecast, is making money at over $100m a year, has well over $200m net cash on the balance sheet, and is valued at $750m.
Occasionally we have to downgrade stocks to a negative recommendation, Take Profits or Sell. If subscribers are invested primarily for income, we do strongly suggest you take some profits or cut your losses for some of your position at least. You can always go back for another look later.

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