One of my areas of personal interest with dividend investing is looking for under the radar dividend firms that are growing rapidly, yet have stable enough business models that they can pay growing dividends. I haven’t been able to find many such businesses in the US to invest in, but I’ve finally stumbled on a couple that I like.
Large cap dividend paying stocks give you good growth, stability of income and progressive dividend increases. Companies that can do this well and do it consistently are a dividend investors ideal candidate for investment. So then why would anyone possibly want to consider small dividend company payers who don’t have the track record of 15-20 years worth of consistent dividend increases?
Large cap dividends are the mainstay of a dividend growth portfolio. They are generally solid, dependable companies that provide consistent dividend increases over a long period of time . I have them in my portfolio as anchor points for dividend payments.
Large cap dividend growth eventually slows
After a certain point in time however, the profit growth rate and operating cash flow growth rate of large companies slows . This is because the business becomes so large and has saturated its market so much that its ability to grow at rates much above GDP becomes difficult to sustain.
Dividend growth can still continue by increasing the dividend payout ratio, but even this has a limit. To make sure I’m getting the maximum dividend income in 20 or 30 years time, I ideally want sustained high rate of dividend increases over the next couple of decades.
Mid caps and small caps have an advantage in that they are in much earlier stages of the business and are experiencing high rates of profit growth in their core business. They can comfortably afford to increase their dividends just through passing on the natural growth that is happening in their business, and companies like Cochlear, (listed on the ASX) have average compounded dividend growth rates of greater than 15% over a decade.
Mid cap dividend payers are hard to find
There is a reason that finding smaller company dividend payers isn’t easy. Typically companies at such an early stage of growth are either reinvesting heavily into their existing business or haven’t attained a level of stability to be in a position to pay out dividends.
Thus its rare to find a smaller company that is able to pay out dividends. However finding a small company that is able to pay out dividends and which has the presence of a some type of moat is potentially promising for sustained and rapid dividend income growth.
I’ve stumbled across a couple of small cap companies that I think have the early signs of a moat, and which are poised to also grow dividends at a modest clip.
United Guardian (UG)
United Guardian is a diversified industrial company that currently pays a dividend yield of 3.2%. It manufacturers and markets a range of health care, cosmetics and personal care products . United’s products can be found in hospitals, as aids to clean catheters, lubricants that are used in personal care products such as creams and lotions and pharmaceutical products used to treat various urology conditions.
United Guardian isn’t a one trick pony, and more relevantly, all its products are protected by a moats which are formed from a combination of product patents and IP that exists around production processes.
But more than trying to rationalize intellectually whether there is a moat, I always like to look at the financials to get a picture of the existence of a moat.
United Guardian’s financials tell an interesting picture.
To start with, United Guardian has no debt, a big plus in my book. Revenue growth has been pretty modest, at roughly 3-4% per year. UG has a pretty small employee base, so they really rely on ramping up distributor capacity to push more volume, no doubt something that they should be able to do more of in a big way, should they choose to.
The gross margin picture is an interesting one. United Guardian has been able to maintain and expand their gross margins over the last decade from 54% to 64%. In conjunction with growing revenues, thats a strong sign that a company has pricing power. Similarly operating margins have also increased from 33% to 45%. Thats also a good sign that the company has been able improve its internal efficiencies in managing each dollar of revenue to profit.
The improving gross margin picture in conjunction with the operating margin picture tells the net income story. In spite of revenue growth being pretty modest, earnings per share have doubled over the last 10 years, with no reductions in share count.
Finally consider United Guardian’s return on equity. This has been consistently in the 20%+ range, and in more recent years has ticked up to mid 30′s. That’s exceptionally strong management of shareholder’s fund to generate returns. The only other company that I know that is anywhere near these levels is Mcdonalds, and we all know how hugely successful they have been as a franchise. $10K invested in MCD 10 years ago would be worth $80k today.
United Guardian’s dividend? It has grown from $0.15 to about $0.92 per share in 10 years. That’s more than 6x growth. Admittedly the payout ratio has gone up over time, but this is a business with many commercial products that are in market, with a distributor go to market model that doesn’t need to reinvest much of its capital into the business.
United Guardian ticks all the boxes for me in terms of what i look at in a potential hidden gem. Best of all, its market cap is under $200m, so there is likely quite some time ahead for the United Guardian story to play out. Just how would you have done if you invested $10k in United Guardian 10 years ago? Well, you’d be sitting on close to $110k today.
I like United Guardian a lot. In fact, I recently made a $4k investment in the company. I’ll look to add to this slowly over the next few years as I see continued improvements in operating results. I’m in no hurry on this one. Its a decades long story in my view.
Female Health Company (FHCO)
I want to thank Zach@DividendLadder for bringing this one to my attention. The Female Health Company is a bit of an innovator in its own right. Its claim to fame is the production of one of the few female condoms available in the market, and the first approved by the FDA.
Now before all of you chuckle too hard, birth control is a big business. The global market for contraception is close to $20B annually. The Female Health Company is a tiny player in this space, with a capitalization of only $250M.
Female condoms are big business in the developing world, Africa in particular, and non government agencies are the Female Health Company’s biggest customers. At around $2 a pop, the female health company’s female condom is about 4x the price of a comparable male condom (around $0.50) each, but it puts women front at centre of the contraception issue.
There’s much time, development effort and unique IP that has gone into the development of the Female Health Company’s product, which is patented. This serves to give the company a moat, and this isn’t something that can be easily copied or imitated.
The Female Health Company’s financials are what I aspire to see in any small cap dividend payer. Revenue has increased more than 4x over the last 10 years, to approximately $37M today. In conjunction with that rapidly growing revenue, this company has significantly grown gross margin during that period also.
Gross margins have increased from 40% to up close to 60%. This company has pricing power in spades, something that is evident from its near monopoly in the market. Its likely also benefitted from economies of scale and cost reductions as volumes have increased.
Operating margins have gone from -14%, to up close to 30% , also a pretty remarkable turnaround in 10 years, for essentially a start up business. Earnings per share are up almost 3x in just 5 years. Finally returns on equity are up near 60%, which just can’t last over the long haul and will probably slowly come down over time as additional players enter this market.
Dividends for Female Health were only introduced within the last 3 years, but growth has been averaging close to 20% per year. With its current dividend, Female Health is yielding about 2.9% per year. And the return on 10k invested 10 years ago? Just under $80k today.
Much like United Guardian, I really like this company. Frankly, I don’t expect it will survive as an independent business for longer than 2-3 years before it gets acquired by one of the major health care players.
In any case, I’m aiming to enjoy both the dividend and capital growth while it lasts, and have made a $5k investment in the company. Its also one that I’ll be happy slowly adding to my stake over the years as operating results improve.
Investing in smaller companies is inherently risky, and certainly more risky than large cap players. Its not for everyone. However the presence of a few things can help derisk that investment for you. Most important is the existence of a moat. This helps to give some comfort that a company’s strong results can continue over the long haul. Not having any debt is also a positive. Finally, the payment of a dividend typically implies stability of a business model and speaks to cash generation and prudent cash management all of which are positives,
In my opinion, both UG and FHCO display many of the qualities that make their businesses investable hidden gems. I’m cautiously optimistic on their future dividend growth and total return potential. Having a very strong core of wide moat large cap stocks helps me accomodate the occasional hidden gem in my portfolio.