Cash is still king but it doesn’t hurt to add some growth to balance out long-term returns. Take advantage of the higher growth potential in smaller companies but look for ones with sustainable payouts.
How the Dividend-Growth tradeoff works
After two stock market meltdowns in less than 15 years, investors have learned that a dividend today is worth much more than the prospect for higher prices in the future. That constant cash return is worth more than just money in your pocket, it means that your total return is cushioned when the market tanks and a quarter of the stock price is wiped out.
But the allure of big money gains is still strong and even the most generous dividend payouts can’t compare to growth stories like Oracle (NYSE: ORCL) and its almost 19,000% return in the ten years to the 2000 peak.
Normally, these high-growth companies are not going to pay a dividend. They keep all cash flow for reinvestment in the company for the promise of a higher stock price. Most dividend-paying stocks, especially those with yields above 2%, are from large companies in mature markets. Growth opportunities are fewer and cash flows are more stable so the company isn’t really sacrificing as much when it pays out a dividend.
Where to find growth without sacrificing income
To find real growth, the kind that won’t disappear when the market tumbles, you have to look to the potential of small-cap companies. These companies with a market cap of $1.5 billion or less use their size to take advantage of opportunities their bigger rivals can’t get to. The business model is usually more focused in a smaller company, without the burden of multiple divisions on a vast international scale.
This size advantage has paid off. Small-cap companies traded on the U.S. exchanges have outperformed their larger peers by almost 2% a year over the last ten years. It may not seem like much but add this to the average market return plus a healthy dividend and you’ve got a powerhouse portfolio.
Finding small-cap companies with growth potential that offer sustainable dividends isn’t easy. Of the 5,340 companies with capitalization of less than $1.5 billion, only 915 (17%) offer a 2% dividend yield or better and half of these are financial institutions.
To build a diversified portfolio of growth companies with strong and stable payouts, you need to dig deeper into the companies with a competitive advantage in a growing market.
The 3 you might not have heard of – Yet.
Female Health Company (Nasdaq: FHCO) produces the only women’s condom approved by the U.S. Food and Drug Administration. The $285 million company sells in 138 countries and has been approved by the World Health Organization for its product to be purchased by UN agencies.
Production almost doubled to 61.6 million units in 2012 with growth seen at 9.7% in 2013 due to bureaucratic delays in Brazil and South Africa. The shares pay a 2.8% dividend yield and the company has increased its dividend by a 12% pace each year since 2007.
The worldwide condom market is estimated to reach 19 billion units by 2015 and currently tops $3 billion in annual sales. With the only other approved product besides the traditional male condom that can protect AIDs and other sexually-transmitted diseases, the potential for growth is huge.
TAL International Group (NYSE: TAL) leases container storage for global transportation and controls about 13% of the global market share in its sector. The $1.4 billion company sees the majority of its business from Europe (44%) and Asia (43%) with the United States accounting for the remainder of sales.
Despite the weakness in Europe over the last five years, this may be a great time to be getting into global transport companies and TAL International. The European region is forecast to break out of recession in the third or fourth quarter of this year and should boost global shipping demand. The company signs long-term leases for its containers which helps to smooth out short-term volatility in demand.
Revenue has grown by an annual rate of 18% every year since the IPO in 2005, even against the backdrop of a global financial crisis. The shares pay a strong 6.2% dividend yield and have increased by an annualized 19% over the last seven years.
Quality Systems Incorporated (Nasdaq: QSII) develops and markets healthcare information systems to automate processes for the medical community. The $1.3 billion healthcare IT company was founded in 1974 and operates in four divisions: QSI Dental, NextGen, Hospital Solutions and RCM Services.
Spending on healthcare in the United States is projected to top 20% of GDP before 2020 due to rising costs and the aging population. Technology solutions to automate and improve systems are seen as the only viable and politically-feasible way to decrease the surging cost of healthcare. The company increased sales by 30% over the last two years with maintenance fees growing to 34% of total sales. The potential for maintenance and fees for ongoing systems management is extremely lucrative and could turn this company into a cash cow.
The shares pay a 3.1% dividend yield and have split three times since 2005. Adjusting for splits, the dividend has increased by 18% on an annualized basis. The stock price could be a little more volatile around announcements over healthcare spending and the national insurance program but the long-term potential for this dividend-payer could be a big bonus to your portfolio.
Higher Return with Less Risk than You Would Expect
Usually, small cap growth comes at the cost of higher volatility and risk but two of these three companies may be the exception to the rule. While TAL International has a beta of 1.89, meaning that the stock price is more volatile than the general market, the other two have betas well under the market. Betas and the riskiness of a stock can change but it looks like the three stocks can make you outsized returns without the outsized risk.
You still may want to load your dividend portfolio with large-cap stocks for the consistency and stability of payout but adding some smaller companies to the mix will help boost growth over the long-term.
Thanks for sharing.
QSII sounded interesting, good prospects, no debt.
But then I saw the P/E of 34 and the rally in july.
I think the stock is overpriced at the moment.
It would have been a nice buy in june though.
Some interesting candidates here. I was invested in QSII previously, really liked the business model. I sold out because their sales traction didn’t appear as solid as I had hoped. One of the trends thats happening in the medical market is consolidation among the physicans, which QSII primarily sells into. Its an interesting space to be invested in. TAL and FCHO will be candidates for more research for me. Thanks for sharing.
Having taken a quick look at both of them, I think both FHCO and TAL look very interesting. Are you planning on taking a position in either? FHCO in particular. High returns on equity, strong revenue growth, good and increasing gross and operating margins. I’ll need to do so additional diligence, but I am tempted to take a modest position in both….
Thanks Integrator. They are definitely two stocks I’m considering as new additions to my portfolio.
Hey Zach, I never heard of those companies! any plan on buying those stocks?
Definitely looking to take positions once I increase cash a bit more.
I bought FHCO in April and it was up about 45% by May and has slowly but surely fallen back to almost no gain. I continued to hold it as it has a monopoly product and does pay a steady dividend ,it also gets you invested outside north America.
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If you had to pick one out of the three recommendations,
which you do think has the best potential.