3 Small Cap Stocks For Growth And Yield

Includes: APO, PSB, TWO
by: Greg Group

As a small cap investor, you should always be on the lookout for stocks with low valuation and growing cash flows. These are the types of investments that can lead the market when in moves into a sustainable uptrend. This article discusses three small caps that are undervalued and have potential to increase dividends in the future.

We remain positive on the mortgage REIT sector as the current environment should allow for the continuation of mid-teens returns on equity. The net interest spread opportunity in the Agency MBS space has contracted during 2011, but remains attractive by historical standards. Risk-adjusted yields have widened on non-Agencies given the general risk-off appetite of the broader markets making the return outlook more favorable for incremental investments. While returns are generally favorable across the residential mortgage landscape we continue to have a preference for the hybrid mortgage REITs given their increased flexibility to allocate capital towards the most attractive risk-adjusted return segment of the markets.

Two Harbors (NYSE:TWO) is a residential mortgage REIT that invests in both Agency MBS and non-Agency MBS. TWO is trading at $9.31 with a P/E of 6.21 and market cap of $1.3 billion. TWO had an increase of 452% in revenue in the past year compared to the previous year. Two Harbors is well positioned to both take advantage of the current environment while acting to protect current returns. We expect Two Harbors to deliver an 18% return on equity for 2012. Based on the combination of the company's asset allocation to both Agency and non-Agency MBS and the level of prepayment protected Agency MBS assets we have a higher degree of confidence around the sustainability of returns for Two Harbors versus peers. Those factors also position Two Harbors to have greater book value stability. Two Harbors is currently trading at third quarter book value and yielding 17.2%.

PS Business Parks (NYSE:PSB) is a self-advised, self-managed equity real estate investment trust (“REIT”) that acquires, develops, owns and operates commercial properties, primarily multi-tenant flex, office and industrial space. PSB is trading at $56.17 with a market cap of $1.4 billion. PSB trades at a healthy discount to both REITs and the Russell 2000 on all of our valuation metrics. A key part of PS Business Park’s cheapness comes from a remarkably low overhead level despite the company’s small size. We estimate PSB’s G&A is only 3-4% of operating income versus 9-10% for the REIT sector as a whole. PSB gets this cost savings in part due to overheads sharing with Public Storage (NYSE:PSA). PSA has about a 40% position in PSB which in turn keeps the free float small. PSB has a dividend yield of 3.13% with a 5-year dividend growth rate of 8.7%.

Apollo Global Management (NYSE:APO) operates a focused business model centered around its leading alternative asset management franchises. The company operates primarily within the private equity and credit asset classes but has been expanding into other areas such as real estate investing. Apollo follows a contrarian, value-oriented investment style in its funds. In keeping with its emphasis on distressed opportunities, the company was among the most aggressive within the industry in deploying capital in recent years.

APO is trading at $12.30 with a market cap of $1.5 billion. We view Apollo Global as an attractive means of gaining exposure to the secular growth in alternative investments and improvement in capital markets conditions. The environment remains favorable for alternative investing, ample capital to deploy, accommodative financing markets and signs of improving M&A and underwriting activity. Given its emphasis on distressed investing, Apollo was among the most aggressive in deploying capital during the down cycle and as markets have rallied Apollo has benefited from the strong returns generated in its funds. We see the cash dividends that Apollo pays to its shareholders from realization of carried interest gains as one of the most critical catalysts and value drivers for the stock. Currently, APO has a dividend yield of 2.28% but we estimate a cash dividend distribution of $1.30 and $1.85 in 2012 and 2013, implying a yield of over 9% over the next year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.