The top 10 small-caps for dividend growth

For many investors the attraction of smaller companies is the potential to ride a wave of soaring growth. Small caps can expand far quicker than larger companies, and strong earnings growth tends to be reflected in rising share prices. So with the expectation of strong future returns, it's understandable why some investors are happy to forego dividend payouts at the smaller end of the market. Yet according to research, companies with a track record of dividend growth can be sending a very positive message about future earnings - so it's worth looking out for them.

In his 1994 book Beating the Street, ex-Fidelity fund manager and investing legend Peter Lynch, noted: "The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row."

What Lynch meant was that as companies grow larger and generate more profits, their stockholders share in that success as the dividends are raised. In other words, rising dividends are a signpost to the earnings growth that is craved by investors in smaller companies.

A signpost to earnings growth

Much of the research into dividend payouts suggests that there are some very influential behavioural factors at play. Company management can be pilloried and share prices slashed when dividend cuts occur. So long-term dividend growth has to be supported by strong confidence in future earnings.

Back in the 1950s, research by finance professor John Lintner showed that companies think very carefully before introducing and increasing their dividends. He found that managers typically "smooth" dividend increases over time. And they only make upward changes when they're sure earnings can support the increase.

More recent work by US fund managers Rob Arnott and Cliff Asness reached a similar conclusion. Their research showed that managers possess private information that leads them to pay out a large share of earnings only when they are optimistic that dividend cuts won't be necessary.

Screening for dividend growth

To get an idea of which small-cap stocks offer a track record of dividend growth, Stockopedia screened the market for Interactive Investor. Apart from a dividend growth streak of at least six years, we looked for companies that are forecast to grow dividends next year and have generated double-digit compound earnings growth over the past five years. The stocks also needed to have a QualityRank of at least 75 (out of 100). This scores and ranks every company in the market using measures of profitability, financial strength and low risk - from zero (low quality) to 100 (high quality).

The yields on offer here range from a modest 1% at specialist software company GB Group to 4.1% at power supply business XP Power. XP is one of five companies boasting a dividend growth streak of nine years. Wealth management firm Brooks Macdonald leads the list, having grown its dividend-per-share by over 36% compounded over the past five years. Communications group Maintel has the highest forecast dividend growth rate for next year, at nearly 30%. Meanwhile, five of these companies have grown earnings at compound rates of more than 20%, including marketing company Cello, agricultural feeds business Anpario and recruitment consultancy Harvey Nash.

One of the arguments in favour of stocks that don't pay dividends is that retaining and reinvesting earnings will create further growth. Often, companies that return cash to shareholders are thought to have nothing better to do with it. But there is evidence that progressive dividend policies are put in place by companies that are very confident about their future earnings. The added bonus is that dividend growth can have a beneficial compounding effect for shareholders.

It's worth remembering that smaller companies can be susceptible to setbacks, and dividends can be cut at any time - so careful research is needed. But in the search for dividend safety, a strong track record could be a useful place to start looking.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"

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