Small Caps with Big Yields

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If you're anything like the average dividend investor, you want one thing: safe, reliable income. Sure, a large payout is nice, but at what cost? A high yield means nothing if it's here today, gone tomorrow.

Maybe that's why investors shy away from stocks with a small market capitalization when looking for income. It's easy to think that, because a company is relatively diminutive, the payout isn't stable or the yield is small. In some cases, that's true. In others, that's mistaken. And investors could pay dearly by losing out on an entire group of well-paying, and sometimes fast-growing, stocks. All it takes to get in on the action is a little homework.

The first thing we want to look for is obvious: small-cap stocks that pay dividends. Technically, these are stocks with a market cap under $2 billion. For our screening purposes, we'll also put a floor in at $100 million. Anything under that, and we're getting into micro-cap territory, which carries more risk than most dividend investors are willing to stomach. We also want to make the search for high yields worth our while, so we'll look for yields above 6.5%.

But we can't just stop there. It's absolutely vital that a high yield is justified -- that is, supported by sustainable cash flow and not on the verge of being cut at the slightest downturn in business. One simple metric we've touched on before is the dividend payout ratio.

Say a company earned $500 million in a year and paid out $250 million in dividends. A little simple math (250/500 = 0.5) tells us that makes for a payout ratio of 50%, meaning the company paid half of its earnings as dividends. A good payout ratio depends on the industry, but anything above 100% means a company is paying out more than it's earning. This should set off warning bells, because it means the company is using cash reserves to meet its current dividend obligations. That can't last long if business doesn't pick up, and the company will either continue bleeding cash or it will have to cut the dividend payment. Neither is particularly desirable.

With these factors in mind, the StreetAuthority research staff came up with the following screen:

• U.S. stocks with market caps between $100 million and $2 billion
• Dividend yield above 6.5%
• Posted positive earnings last quarter and on a trailing twelve month basis
• Dividend payout ratio under 65%

Here's what we found:

There are two standouts in this table and one obvious red flag.

Internet Service Provider Earthlink's (Nasdaq: ELINK) best days are behind it. Its customer base does churn out enough cash to support its 6.5% yield with room to spare, but macro factors are set to crush this small company. The company focuses on retaining existing dialup customers who have not switched to broadband Internet access because of either price or availability. But as the old adage goes, "If you're not growing, you're dying." Internet service is getting cheaper, faster and it's expanding into more parts of the world as we speak. Customers are growing to expect more bandwidth and competitors like AT&T (NYSE: T) and Verizon (NYSE: VZ) will be all too happy to expand into the areas Earthlink services and seal this company's fate.

The two standouts from this list are Buckle (NYSE: BKE) and International Shipholding (NYSE: ISH).

Buckle is a clothing retailer that sells simple, fashionable styles to the younger crowd, not the high-fashion type of retailer that might get left out if it misses the mark on evolving trends. When other retailers felt the hit of lower consumer spending during the downturn, Buckle turned in solid results in fiscal 2009, growing revenue and profits. The company has focused on steady growth over the years and pays out less than a quarter of its earnings, yet still yields 8.5%. (Note: The bulk of Buckle's payout is in the form of a "special" dividend based on earnings).

Mobile, Alabama-based International Shipholding is a maritime transporter with a fleet of 41 vessels that transport everything form cars and trucks to military equipment. The Baltic Dry Index dropped like a rock when the economic downturn hit, reflecting the woes of the shipping industry. The index has staged a comeback of late, but it could be just the beginning. As for International Shipholding, the stock carries a price-to-sales ratio of just 0.6 and trades for just under five times earnings, suggesting it is ridiculously undervalued. And with a yield of close to 7.0% and a payout ratio of 34%, the dividend looks to be in good shape, too.

April 30, 2010By: Brad Briggs