When choosing stocks to add to a dividend portfolio, an overwhelming majority of investors probably look no further than the S&P 500. And a great many have done just fine doing so. Warren Buffett has made billions upon billions of dollars over the years through his investments in Coca-Cola (NYSE:KO), IBM (NYSE:IBM), Wells Fargo (NYSE:WFC) and the like.
But let's face it: Very few investors have the resources to open a 150 million-share position in American Express (NYSE:AXP), or a 52 million-share position in Procter & Gamble (NYSE:PG). Individual investors like myself and most of the Seeking Alpha audience have to start out small. And rather than putting all of our eggs in one basket, it's smart to diversify, often with 100 or 200-share positions in companies across a broad spectrum of sectors.
Investors who are less prone to risk aversion might also seek to diversify their portfolios with stocks from differing levels of market capitalization. Investors in small caps are often rewarded handsomely for their research and risk. Indeed, according to investing consulting firm Ibbotson Associates, small cap stocks increased in value by an average of 12 percent per year between 1927 and 2007. During the same period, large cap stocks increased by an average of 10 percent.
Why the discrepancy? One obvious reason is that small cap companies are often unrecognized by the vast majority of investors and media outlets. A positive news event or a good earnings report might not be noticed for days or weeks, giving savvy investors the opportunity to buy before the market. Along the same line, small caps are often covered by only a handful of analysts, while large caps can be covered by dozens. An analyst upgrade of Chevron (NYSE:CVX) or McDonald's (NYSE:MCD) might move the stock price a point or two; while an upgrade of a small cap might send the stock price up 10 or 20 percent. This, of course, could be a double-edged sword, as an analyst downgrade could tank the stock price.
Another advantage that small cap companies enjoy is efficiency. An inefficient or costly policy or procedure that might take months or even years to change through the bureaucracy of a large cap firm might take weeks to change at a smaller company.
Finally, a great number of small cap companies seemingly always have a target on their backs. When a small company has an asset that a larger company wants, it's often easier and cheaper to buy the company outright, rather than spending vast sums of money trying to come up with a comparable product from scratch. The acquiring company often pays a sizable premium to shareholders of the target firm.
The problem many investors face in researching small cap stocks is the time it takes to first find, then research the companies. There is a plethora of information on large cap stocks, more than most people would have the time or the willingness to evaluate. Information on small cap companies, many of which most people have never heard of, is not nearly as prevalent. There could be weeks between headlines containing new data in addition to the companies' quarterly earnings reports.
I have run a screen for small cap stocks with the following parameters:
- Price-to-earnings ratio of 20 or less
- Dividend yield of 2.5 percent or greater
- Payout ratio of 70 percent or less
- Price-to-book ratio of 3 or less
- EPS growth rate of 7.5 percent or greater over the next five years
This list is nowhere near comprehensive, but I hope it will provide investors with a starting point for research into small cap investing. Data and company profiles are from Yahoo Finance and Google Finance.
A. Schulman, Inc. (NASDAQ:SHLM) is a supplier of plastic compounds, resins and services. The Company's customers span a range of markets, such as packaging, mobility, building and construction, electronics and electrical, agriculture, personal care and hygiene, sports and leisure, custom services and others. The Company's operating segments include Europe, Middle East and Africa, the Americas, and Asia Pacific. A. Schulman operates primarily in four lines of business: masterbatch, engineered plastics, specialty powders and distribution services. A. Schulman, Inc. was founded in 1928 and is headquartered in Akron, Ohio.
SHLM trades at a 15 percent discount from its 52-week high. Its plastics business is highly leveraged to the auto industry; so as vehicle sales continue to improve, SHLM's revenue should pick up, as well. The dividend yield is generous at 2.8 percent, and seems safe with its corresponding 45 percent payout ratio. The company has raised its dividend by 30 percent over the last five years. With a Graham fair value of $26.55, a forward P/E of 11.66 and 8.8 percent projected annual EPS growth over the next five years, SHLM appears to be attractively priced.
American Railcar Industries, Inc. (NASDAQ:ARII) is a North American designer and manufacturer of hopper and tank railcars. The Company also leases, repairs and refurbishes railcars, provide fleet management services and design and manufacture certain railcar and industrial components. Its primary customers include companies, which purchase railcars for lease by third parties, or leasing companies, industrial companies and those, which use railcars for freight transport, or shippers, and Class I railroads. The Company operates in two segments: manufacturing operations and railcar services. Manufacturing operations consist of railcar manufacturing, railcar leasing and railcar and industrial component manufacturing. Railcar services consist of railcar repair, refurbishment, engineering and fleet management services. American Railcar Industries, Inc. was incorporated in 1988 and is headquartered in St. Charles, Missouri.
ARII trades at a 25 percent discount from its 52-week high. Crude-by-rail traffic is expected to increase by 300,000 units in 2013, nearly offsetting a drop in coal traffic in 2012. On top of that, coal is moved along a rail network that has been established for decades, while crude oil traffic is along a network that is still in development. Carl Icahn holds 55 percent of the outstanding shares of the ARII. The dividend yield is very generous at 2.9 percent on a very safe 31 percent payout ratio. The Graham fair value is $36.22, forward P/E is 8.54 and analysts expect annual EPS growth of 15 percent over the next five years. ARII appears to be undervalued at this level.
Espey Manufacturing and Electronics Corp. (NYSEMKT:ESP) is a power electronics design and original equipment manufacturing company engaged in developing and delivering products for use in military and severe environment applications. The Company's primary products are power supplies, power converters, filters, power transformers, magnetic components, power distribution equipment, ups systems, antennas and high power radar systems. The company markets its products primarily through own direct sales organization to industrial manufacturers, defense companies, the United States government, foreign governments, and foreign electronic equipment companies. Espey Mfg. & Electronics Corp. was founded in 1928 and is based in Saratoga Springs, New York.
ESP trades at a 16 percent discount from its 52-week high. On Feb. 27, ESP's CEO purchased 350 shares of the company at $26.33. The current price offers investors a discount on the cost basis of this insider purchase. The high dividend yield of 3.8 percent appears to be safe, with a payout ratio of only 47 percent. The Graham fair value is $25.11, forward P/E is 11.70 and analysts project 5.7 percent EPS growth next year. At the current level, ESP is attractively priced.
Schweitzer-Mauduit International, Inc. (NYSE:SWM) is a diversified producer of specialty papers. It operates in two segments: Paper and Reconstituted Tobacco. It manufactures and sells paper and reconstituted tobacco products to the tobacco industry, as well as specialized paper products for use in other applications. It operates in two segments, Paper and Reconstituted Tobacco. The Paper segment primarily produces cigarette papers, such as lower ignition propensity papers, plug wrap papers, and base tipping papers used to wrap various parts of a cigarette. This segment also offers commercial and industrial products, including lightweight printing and writing papers, battery separator papers, drinking straw wraps, filter papers, and other specialized papers. The Reconstituted Tobacco segment produces and sells reconstituted tobacco leaf, and wrapper and binder products. The company sells its products directly to cigarette and cigar manufacturers, converters, and other end-users or brokers in approximately 90 countries. Schweitzer-Mauduit International, Inc. was founded in 1995 and is headquartered in Alpharetta, Georgia.
SWM is only 1 percent off of its 52-week high. SWM is the world's largest manufacturer of cigarette papers, with customers including Philip Morris USA, Philip Morris International and British American Tobacco. The company has an expanding presence in Asia, with 12 percent of 2012 sales coming from China alone. SWM pays a nice 2.8 percent dividend, on a modest 48 percent payout ratio. The Graham fair value is $33.70, forward P/E is 10.57 and analysts project 15 percent growth over the next five years. SWM is an attractively priced growing company.
Conclusion: Investing in small cap stocks requires a substantial amount of research and willingness by investors to take on more risk than that of large caps. The stocks I have listed provide investors with both value and substantial dividend yields. However, these are only four of many quality small caps on the market. I hope that investors interested in small caps will use this list as a starting point for their own research.