Friday, May 16, 2008

Paying Big Dividends

The financial pundits have been making a big deal about dividends recently. Investors looking for some relief from volatility in the U.S. equity market might consider holding more cash. However, low interest rates and rising inflation make money market funds a risky proposition. Investing in dividend paying stocks makes sense as a hedge against inflation.

Focused as we are on the small cap sector, dividends typically do not figure prominently in our stock selection processes. However, we know dividends are not limited to the large- and mid-cap sectors. So we completed a search for small-cap companies paying big dividends.

It made sense to simply eliminate certain troubled industries, such as home builders, banking and finance. Another important factor is beta, a measure of how volatile the stock is compared to the general market.

Our initial screen returned 160 companies under a market cap of $1.5 billion. We chose those with dividend yields over 4.0% and beta measurements under 1.3. That exercise winnowed the group down to 20 companies.

It is not enough to simply look for the highest dividend yields. After all, the dividend yield could be high because a low stock price reflects problems with operations. We looked at the ability of the companies to generate cash - a signal of both healthy operations and ability to pay dividends. The measure we used was cash conversion - cash flow from operations divided by revenue. We compared the cash conversion ratio from the most recent twelve months to the same measure for the last five years combined. Next we looked at consistency in dividend payments.

Fourteen of the companies on our list had five-year cash conversion ratios higher then 20%. That means for every sales dollar that comes in the door, the company can put two dimes or more in the piggy bank for capital investments, acquisitions and dividends. Thirteen of the twenty companies have been paying dividends for five years or more.

We picked five stocks at the top of the list and will profile each in future posts. The industries represented include telecommunications, transportation and shipping, and one big surprise - publishing.

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