Many dividend-seeking investors are overly focused on high-yielding large cap stocks and that could prove to be their Achilles Heel as they end up with an over concentrated portfolio of stocks that typically includes the big banks such as Commonwealth Bank of Australia (ASX: CBA), insurers like Suncorp Group Ltd (ASX: SUN) and a handful of industrials.
Don't get me wrong – these are good stocks to hold for any income investor, but it can be a costly mistake not to include a select number of small cap stocks as well to better diversify risk given that the performance of large and small caps is often uncorrelated, and at times, can be inversely correlated.
Another reason why small caps with reasonably high and dependable payouts should be added to your portfolio is because they generally have a greater ability to increase their dividend payments over the short and longer term.
An example of a solid dividend-paying small cap is hospital equipment supplier Paragon Care Ltd (ASX: PGC). The trailing yield on the stock is nothing to get excited about as it's hovering around 3%, or 4.2% once franking credits are added, but its dividend has nearly doubled in three years from 1.25 cents a share in FY14 to 2.2 cents in FY16.
This means Paragon Care could potentially be producing a grossed-up yield closer to 8% over the next few years as long as it can maintain its growth momentum. Paragon Care has managed to achieve its stellar growth rates through an aggressive acquisition strategy, which saw its revenue surge to $93.4 million in FY16 from $19.4 million just two years ago, while earnings before interest, tax, depreciation and amortisation (EBITDA) has jumped to $12.1 million from $1.8 million over the same period.
Management is forecasting revenue of between $115 million and $120 million this financial year and EBITDA of $15.7 million to $16.7 million.
I don't typically like roll-up type businesses, but its track record and quality of management gives me confidence that the company can keep growing at a double-digit pace. I have spoken with its managing director Mark Simari a number of times over the years and he has proven to be a conservative manager who under promises and over delivers.
In many respects, Paragon Care reminds me of another small cap star, auto services group AMA Group Ltd (ASX: AMA), and the medical equipment supplier has plenty of growth levers to pull given the fragmented nature of the industry.
Another small cap stock that is worth considering for your income portfolio is Bell Financial Group (ASX: BFG). The stockbroking, investment and financial advisory group is trading on a trailing dividend yield of 8.8%, or around 12.6% with franking.
Bell Financial posted a very credible full year result in February (its financial year ends in December) as it managed to eke out growth in an industry that is in a retreat. What's more, the growth momentum has been sustained in the first quarter of FY17 with revenue up 16% over the same period to $43 million as pre-tax profit more than doubled to $4 million.
However, its high yield indicates that the market is sceptical about Bell Financial's ability to sustain its dividend. Could the stock be a yield trap?
The issue is that its FY16 dividend has increased 22% to 5.5 cents a share while net profit is only up a more modest 3% to $16.4 million. Further, the FY16 dividend represents a payout ratio of 88%. That is very high and investors have the right to wonder if the ratio is sustainable.
On the upside, Bell Financial's strong market position and my expectations for equity markets to remain buoyant for this year, if not beyond, gives me some confidence that management will be able to at least hold its dividend steady.
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