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All Contents © 2018The Kiplinger Washington Editors
By Tom Petruno, Contributing Writer
| December 2016
Small companies have been the stock market's stars this year, with the benchmark Russell 2000 index up a hefty 24%—nearly double the gain of the blue-chip Standard & Poor's 500-stock index.
As with the broader market, most of the gains for small-capitalization stocks have come since Election Day. Investors are betting that President-elect Donald Trump's policies will boost the U.S. economy in 2017. That could favor smaller companies over multinationals because the former often do most of their business domestically. Smaller firms also could benefit substantially from Trump's promises to cut business tax rates and ease regulation.
But with many small stocks selling at rich levels relative to earnings, investors hunting for ideas might want to consider shares that offer a potential buffer: a cash dividend. Although dividend yields for many small-cap stocks are modest, a business's willingness to pay dividends—and regularly raise them—can be a sign that the company has financial discipline, and that its interests are aligned with those of shareholders.
We picked eight dividend-paying small companies that we believe also have solid growth prospects over the next five years. But note: Given the market's high valuations, investors should be prepared to be patient.
Share prices and related figures are as of December 20. Price-earnings ratios are based on estimated 2017 earnings per share. Earnings estimates are courtesy of Zacks Investment Research.
Share price: $44.20
Market capitalization: $2.9 billion
Price-earnings ratio: 18
Dividend yield: 4.2%
The business: B&G Foods' roots go all the way back to 1889 (Bloch & Guggenheimer pickles). But the company's modern history began in 1996, when private investors acquired the B&G product line and set about building a food conglomerate. The idea was to buy up so-called heritage brands and try to reignite demand. B&G's pantry now contains more than 40 old-line brands, including Cream of Wheat, Green Giant, Molly McButter, Mrs. Dash, Ortega and Polaner.
Growth outlook: B&G's strategy of "buy it and fix it" is classic Wall Street. The big challenge is that B&G is going against the tide by focusing on frozen foods and so-called shelf-stable packaged foods at a time when many consumers want fresh fare. But RBC Capital, one of B&G's bankers, says one of the firm's strengths is its eye for promising smaller brands "below the radar" of the food titans. So far, acquisitions have boosted annual sales and profits from $500 million and 44 cents per share, respectively, in 2009, to a projected $1.4 billion and $2.18 in 2016.
The dividend story: B&G's annualized payout now is $1.86 per share, after a 10.7% increase announced in November. That puts the stock's yield at a rich 4.2%, far above the yields of industry giants such as Conagra Brands (CAG), at 2.1%, and Nestlé (NSRGY), at 3.3%. RBC says B&G's hefty dividend is intended to send a message to investors that the firm generates a lot of cash and intends to share it. If B&G's strategy works, shareholders could continue to have the best of both worlds—a rising share price and a growing dividend. But investors also need to be mindful of the costs as B&G expands by acquisition: rising interest expense and the issuance of more shares to pay for those deals, diluting current shareholders.
Share price: $34.35
Market capitalization: $1.3 billion
Dividend yield: 0.8%
The business: The company has built a billion-dollar business as an installer and servicer of heating, cooling and plumbing systems in manufacturing plants, hospitals, hotels, schools and other kinds of large buildings. It operates from 91 locations nationwide.
Growth outlook: Comfort Systems went public in 1997, when it had $167 million in annual sales. Within 10 years, revenue topped $1 billion, helped by acquisitions. Growth stalled in the aftermath of the financial crisis, and investors largely ignored the stock from 2008 through 2012. That changed as business picked up in 2013. This year, revenues and profits are on track to hit record levels of $1.66 billion and $1.74 per share, respectively. In its report on third-quarter results, the company said it had seen conditions in its core commercial-building market improve, particularly for retrofitting older buildings with new systems. Planning for 2017, "We are probably more optimistic than usual," CEO Brian Lane told investors after release of third-quarter results. Importantly, Comfort Systems' profit margins are at all-time highs—an indication that it isn't sacrificing pricing to get new work.
The dividend story: With a current annualized payout rate of 28 cents per share, Comfort Systems' dividend yield is modest. But the company made a point of maintaining the disbursement through the financial crisis. The most recent hike was a 7.7% increase last April. The company has financial flexibility thanks to the hefty amount of cash the business generates and a nearly debt-free balance sheet. Brokerage KeyBanc Capital Markets says Comfort Systems' financial strength—and willingness to buy back shares—also should provide a "cushion" for the stock when the market weakens.
Share price: $15.65
Market capitalization: $2.0 billion
Price-earnings ratio: Not meaningful
Dividend yield: 6.4%
The business: Covanta is one of the world's largest waste-to-energy companies. The company operates 41 incinerators nationwide that turn waste into electricity for sale and produce metals for recycling. Research firm Morningstar estimates that Covanta processes about 5% of the nation's total solid waste annually.
Growth outlook: Covanta grew rapidly from 2004 through 2010, but it has been in sort of a holding pattern since, with annual sales stuck at about $1.6 billion. The stock, meanwhile, is about half of its peak price in 2008. The argument for owning Covanta shares comes down to this: After probably breaking even in 2016 and 2017, sales and earnings should improve significantly in 2018 and beyond, partly because of a major new plant coming online in Ireland and the ramp-up of a big contract with New York City. Morningstar thinks Covanta's annual revenue could reach $1.9 billion by 2020. Longer-term growth will depend on whether Covanta can convince more municipalities to choose incineration over landfills—a tough battle, though perhaps less so in crowded Europe. Success also will depend on electricity’s price in comparison with the price of natural gas, a rival fuel, as well as Covanta's ability to borrow money as needed (not a problem so far).
The dividend story: At the current share price, the dividend yield is a whopping 6.4%. Even as reported income stagnated after 2010, Covanta opted to boost its dividend substantially—from an annualized 30 cents per share in 2011 to $1 by late 2014. The payout has held steady since. The message to investors: The company generates enough cash to pay dividends as it makes the transition to its next phase of growth. CEO Stephen Jones has continued to stress that Covanta is "committed" to its dividend. But the stock's weakness shows the market isn't convinced.
Share price: $101.49
Market capitalization: $2.6 billion
Price-earnings ratio: 12
Dividend yield: 1.0%
The business: Lithia has grown into one of the nation's biggest car dealers, with 153 stores in 17 states. It is diversified across 31 brands, including Ford, General Motors, Honda, Mercedes-Benz, Subaru and Volkswagen. The company makes money from selling both new and used cars, as well as from its dealer service departments.
Growth outlook: Boosted by acquisitions, Lithia's sales are expected to reach a record $8.8 billion in 2016—more than double the 2013 total. Earnings also are expected to hit a new high, at about $7.43 per share. But investors have been wary of the stock over the past year, fearing that auto sales are peaking. Lithia's share price is now about 20% below its record high, set in late 2015. There's little question Lithia will suffer in the near term if car sales slide sharply.But a key part of the company's long-term appeal is its dominance in rural markets. "Nationwide, 80% of Lithia-brand stores have no competitors within 100 miles," says research firm Morningstar. In 2014, Lithia further diversified its business by acquiring a host of dealers in Southern California and in the New York City area. As the dealer business continues to consolidate, Lithia will likely have "no shortage of acquisition candidates," Morningstar says. In that sense, a cyclical industry downturn is a long-term positive for Lithia's growth.
The dividend story: Lithia eliminated its dividend in 2009, in the midst of the auto-industry crash during the financial crisis. But the company resumed payments in 2010 at an annualized rate of 20 cents per share, and it has since quintupled that, to the current $1 per share. The stock’s 1% yield isn’t much. But the company's dividend generosity since 2010 at least demonstrates its intent to provide shareholders with regular income growth.
Share price: $60.00
Market capitalization: $3.2 billion
Price-earnings ratio: 17
Dividend yield: 1.1%
The business: Launched in 1961, MKS made its name as a provider of quality-control equipment for the semiconductor industry. Its instruments measure, control and analyze manufacturing processes for computer chips and other industrial and health care equipment. This year, MKS made a major move to diversify by buying Newport Corp., a producer of lasers and other equipment used in chip manufacturing, scientific research and defense.
Growth outlook: The semiconductor industry is notoriously cyclical, which has caused wide swings in MKS's revenue over time. Although sales have grown consistently since 2013, at $814 million in 2015, they still were below the annual record of $853 million, set in 2010. But in the third quarter the company cited particular strength in semiconductor-equipment sales tied to new chip designs that MKS said are in their "early stages" of industry adoption. Brokerage Stifel, Nicolaus expects MKS's semiconductor-related sales to jump 10% in 2017, including Newport's contributions. Analysts on average predict that MKS will earn $2.92 per share on sales of $1.3 billion in 2016, rising to $3.49 per share and $1.5 billion in 2017. Another long-term draw, says brokerage D.A. Davidson: China's semiconductor market is "just beginning what should be a 10-year investment phase, and we believe MKS will be one of the beneficiaries."
The dividend story: MKS started paying dividends in 2011 and has raised the payout at a slow but steady pace, to the current annualized rate of 68 cents per share. The stock’s 1.1% yield is modest. But even though the company took on debt to pay for its $1 billion acquisition of Newport, MKS had cash and investment holdings of $420 million as of September 30. The gives it plenty of resources to continue funding and raising its dividend.
Share price: $69.66
Price-earnings ratio: 22
Dividend yield: 1.9%
The business: Founded in 1914 to develop safety systems for coal mines, MSA Safety says it is now the global leader in worker- and facility-safety products for many industries. Its lineup includes specialized helmets, gas- and flame-detection devices, breathing apparatus, and devices to protect workers from falling.
Growth outlook: Annual sales have stagnated at roughly $1.1 billion since 2011, suppressing earnings as well. With about half of its sales coming overseas, MSA’s profits have been clipped as the dollar's rise against many other currencies since 2011 has devalued foreign sales. At the same time, weakness in the economies of emerging nations has depressed demand for equipment. MSA was also hurt by the crash of the energy industry, which provides about one-third of its sales. But profits rebounded in 2016, thanks in part to a new cost-cutting program. In the first nine months of the year, earnings increased 34% compared with the same period in 2015 on a 4% rise in sales. Wall Street remains upbeat about MSA's long-term prospects, especially in emerging markets and with public safety agencies looking to protect first responders with state-of-the-art equipment. Brokerage Robert W. Baird thinks MSA's sales can grow at a "mid to high single digits" percentage rate over time.
The dividend story: MSA has been a consistent dividend raiser, even through the financial crisis. But the pace of annual increases has slowed over the past three years amid earnings weakness. The most recent hike was 3% last spring. But some analysts advise short-term caution because they worry that the shares, which have jumped 65% so far this year, are looking pricey.
Share price: $93.93
Market capitalization: $2.1 billion
Price-earnings ratio: 11
The business: The nation's third-largest chicken farmer, Sanderson Farms may be the riskiest of our eight picks. As a player in a commodity business, the company is at the mercy of volatile variables, including weather and feed-grain prices. Yet it managed strong growth over the past 10 years, and it has been particularly generous with dividends over the past three years.
Growth outlook: Sanderson, which supplies fresh and frozen chicken to supermarkets, restaurants and food-service firms, has ridden surging demand for poultry in the U.S. and abroad. Sales hit a record $2.8 billion in the fiscal year that ended October 31, up from $2 billion five years ago. But market volatility showed in 2016 earnings, which fell 12.5% from the previous year, to $189 million, or $8.37 per share. Results were hurt early in the year in part by the temporary bans that many foreign countries placed on U.S. poultry exports because of an avian flu outbreak (now passed). But a jump in exports in late summer and early fall helped give Sanderson's earnings a big lift in the August–October quarter. Brokerage CLSA expects the company's focus on expansion to continue boosting its market share—to 9% by 2018,from 7% in 2014. The question is whether key variables, especially feed costs (40% of total expenses), will help or hurt Sanderson's earnings in the near term even if its market share grows. Another risk: questions raised in recent months about alleged price collusion among the largest chicken farmers, including Sanderson.
The dividend story: The company's current annualized dividend is 96 cents per share, about double the level from 10 years ago. And Sanderson has surprised shareholders with special year-end payouts the past three years; this year's was $1.24 per share. Analysts aren't counting on additional special payouts in the next few years. But with zero debt and $234 million in cash, Sanderson retains a lot of financial flexibility.
Share price: $79.00
Market capitalization: $3.5 billion
Dividend yield: 1.5%
The business: Over the past 30 years, Sensient Technologies, which got its start as a whiskey distiller in 1882, has transformed itself into a producer of flavors, fragrances and colors used in a wide range of products—including food, beverages, drugs, cosmetics and industrial goods. The company has been consistently profitable, even through the financial crisis.
Growth outlook: Sensient has about 5% of the global market for flavors, fragrances and colors, research firm Morningstar says. That's modest compared with industry titans such as International Flavors & Fragrances (IFF) and Switzerland's Givaudan (GVDNY). But Morningstar says Sensient has focused on developing customized formulations for individual clients, allowing it to become the sole supplier to those customers. That's a better business than producing commodity flavors or colors. For the past five years, however, overall annual sales have been stuck at about $1.4 billion. Slow growth has been partly a function of a restructuring plan launched in 2014 to close poorly performing plants, with the goal of boosting profit margins. With the revamp expected to wrap up in 2017, brokerage KeyBanc Capital Markets says, Sensient can focus again on driving sales growth, while reaping the benefits of more-productive operations.
The dividend story: The company has been committed to raising its dividend, increasing it even during the financial crisis. The last increase, an 11% boost in November, lifted the annualized payout to $1.20 per share. KeyBanc says Sensient's finances and healthy cash generation give it "plenty of ammunition" in deciding between funding growth and returning cash to shareholders through dividends and stock buybacks.
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