The challenge with small cap dividends

When you see the dramatic gains that small cap dividend stocks are able to eke out it, it’s sometimes easy to forget about the challenges of owning such companies. A couple of recent events served to reinforce these small cap challenges for me.

I’ve had a great success with owning small company dividend payors. In fact, I consider these companies the gems of my dividend portfolio. They can power high dividend growth and significant total returns. You get to have your dividend income, and get your capital growth as well!

Why do I own small cap dividend companies?

Leaders of tomorrow

I have a core set of mature dividend paying companies in my portfolio. These companies have been producing consistently growing earnings for years, and given their wide moats, I have every reason to believe that they will continue to produce growing earnings and large dividend increases for years to come. However the growth of larger companies eventually slows.

There will eventually come a time where there are only so many more places that you can go where McDonalds doesn’t have a restaraunt. Eventually for AT&T and Verizon, everyone will have a smartphone, so the feature phone to smartphone upgrade will slow.

In my view, it’s key to have a diversified portfolio of businesses that are at different stages of growth. You want some emerging companies that can make up for the inevitable declines in growth that your stalwarts will have. That doesn’t mean a need to rush out and buy a bunch of very early stage, speculative companies that have just started introducing dividends, but a blend of companies that are early stage dividend payers as well as mid cap dividend company payers as well.

Small, highly profitable niches

Small cap dividend companies have the advantage of being focussed on fairly narrow profit niches which keep them insulated from their larger rivals. Before larger competition notices what has gone on, the smaller company has managed to expand a market category into a fairly sizeable niche where it is an established market leader.

The Female Health Company for example is the pioneer of the female condom. The niche is small, well under the attention of most players in the contraceptives market. While there are a couple of smaller competitiors, Cupid being one, neither have the scale or distribution, or NGO relationships of Female Health Company. Of course male contraceptive items tend to to dominate the overall contraceptive market, but the female condom could be a nice little earner.

United Guardian is an emerging small cap dividend payer with a number of small, highly profitable niches which are enough to sustain a fairly nice business for the company, but not large enough to encourage competitors to come calling in any serious way. Catheter cleaning is not a large enough market to get companies like Johnson & Johnson excited, however United Guardian has a nice little business going doing exactly this (among other things).

Immunity to economic cycles

While no business is truly immune to a significant economic downturn, companies that are in the early stage of building a business with new untapped demand will have more immunity that most. Companies like Medidata Solutions are just now riding the growth curve of capturing big pharma R&D spend toward cloud based testing and development. An economic downturn won’t materially impact the company given the large cost savings they deliver vs pharma companies doing their R&D in existing ways at 2-3x the cost.

What are risks?

Other smaller Competitors flooding market niches

While emerging market niches may be under the radar of larger players , that doesn’t mean that other emerging start ups won’t see a lucrative business opportunity to go after that will sustain them very nicely.

While Female Health is the dominant female condom provider, Cupid seems to be gaining traction and scale, and concluding agreements to ramp up supply to NGO’s. I still have great doubts that they will be able to close the gap to Female Health, but they do appear to be ramping up their game.

The absence of a clear wide moat

First mover advantage is a significant advantage in any market. It gives you the time to establish a brand, develop key relationships and embed switching costs into a business model. The problem with nascent, emerging markets is that new companies just haven’t been around long enough to do all these alone for any sustained length of time.

At best, they’ve got the beginnings of an emerging narrow moat. Of course, if something is uniquely patent protected and can be replicated than a company may have a more enduring moat, but there isn’t that longevity there yet to necessarily convince any one that they are the best.

Volatility

The key with investing in and holding small cap dividend payers is that you need to have a long, lengthy outlook. While this is true of investing in equities generally, it’s particularly the case with early stage companies.

Why? In many cases, the runway or path forward isn’t clear yet. Smaller companies can make for a bumpy ride. They can have cost blowouts quarter to quarter, lumpy cash flows, product disruptions from understocking or overstocking as they try and finetune demand. All of the earnings hiccups that larger companies are prone to  are magnified, 10, 20x when you deal with emerging companies.

And that’s reflected in how they trade in the stock market.

Just recently, a few of the smaller cap dividend companies that I own have gone through a bunch of turbulence.

  • Energy Action announced that their earning guidance would be “flat” for 2014. No decline mind you, just muted growth given some product transition. They were savaged by the market. The stock dropped almost 20% in one day. Now ordinarily for a larger company, flattish growth may bring some concern, maybe your stock drops 2-3%, but you won’t get 20% declines. That’s enough to make anyone question whether its worth hanging on.
  • Silverchef, another one of my small cap ASX listed dividend payers announced an earnings decline of 10% for 2014. It’s stock dropped almost 40% in one day. How’s that for a beating. Again the longer term trends for this company are still very much in tact. Some minor product issues have led to a deferral of revenue from 2014 to 2015.
  •  Female Health Company- This is probably one of the more puzzling ones. On no real news, the stock has dropped close to 15-20% over the last few months. It’s almost like a balloon slowly deflating. I haven’t seen any negative news that has some out that would justify the volume of the price deflation on this one, and valuation of the company still appears reasonable.

The real issue for small caps is that they tend to be so volatile that small events can create major fluctuations in stock price. Inevitably, the peaks and troughs smooth themselves out over days, once sanity returns to the market, but the knee jerk impacts can trigger short term violent reactions  that can prompt selling by investors without conviction.

Long term holding of small company dividend paying stocks can generate considerable total returns. I have had companies that have returned 3x within the space of 2 years. The key is though, you need to have the conviction to hold these companies for lengthy periods to realize those returns.

But the intense volatility that comes with minor fluctuations in earnings or product hiccups mean that you need to have a particularly strong stomach to hold these companies given how shaky the ride is. Unlike large caps, you need to be additionally worried about the nascent business models and smaller, unknown competitors in addition to the roller coaster ride of the psychological aspects that go along with owning these companies.

As a postscript, Energy Action has managed to claw back most of the 20% loss that it had a few months ago. I’m now patiently waiting for the other couple of small cap dividend payers to do the same :)

 

Comments

  1. Hang on to those bootstraps! I’ve been watching FHCO myself for the last eight months or so and the stock movement is just something funny to watch. No rhyme or reason at all for some of the fluctuations. As you’ve said very well above, that is just some of the challenges of investing in small cap equities. Also another reason why the little guys shouldn’t dominate a portfolio, but instead should be a smaller featured piece to help increase and drive overall returns.

    Best of luck with these selections. I’m sure over the next couple years they will see some increased market traction and some price stability.

    • Integrator says:

      Lol looks like my comment about volatility was very timely, look out below indeed!. These are the times when owners of small caps stocks really find out if they should be in these or not :). Good point on the portfolio allocation. I think starting out small and mid cap shouldn’t be more than 5% of the portfolio. I’ve steadily increased my exposure, but it doesn’t mean I enjoy the big dips any more than I used to!

  2. Moneycone says:

    I actually own FHCO! Excellent profit margins and a growing business. Yes, has its ups and downs but that comes with the small cap territory!

    If you want to get richer (or poorer), quick, small caps can show you the way!

    • Integrator says:

      I still really like FHCO. In addition to its competitive strengths, it also has negligible debt, which is another big tick in my book. Patience with this company is likely to yield strong results over the long term.

  3. I do love them small caps. All you need is one or two to hit and it will cover all your losses. Index funds are my fall back.

    • Integrator says:

      Charles, I think that’s a big part of the attraction for me as well. A trickle of stocks sprinkled in your portfolio that you can swing for the fences on can do big things for total return and asset accumulation. I guess the challenge is finding the right ones to take a swing on :)

  4. Martin says:

    I think as long as you can establish some dividend history of the stock, then it doesn’t matter whether it is a small cap or a large cap. Then you need to stomach the volatility. But today even large caps can be pretty volatile. Just look at MCD or AT&T.

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