3 small-cap dividend stocks for your shopping basket

Those investing for income shouldn’t ignore these market minnows.

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Counterintuitively, it can sometimes be safer for income investors to look lower down the market for their dividend fix. Thanks to their need to keep a closer watch on their balance sheets, smaller companies can often be more financially disciplined than their larger peers, thereby making their bi-annual payments more secure. 

With this in mind, let’s look at three companies that may currently be flying under the radars of many dividend hunters.

3 dividend demons

While shares in £220m cap windows and doors supplier, Safestyle (LSE: SFE) will always be linked to the somewhat unpredictable housing market, the company’s performance has been anything but erratic in recent times. Thanks to consistent annual increases in revenue and net profits, earnings per share for the current financial year are predicted to be triple what they were back in 2011. With stock trading on a price-to-earnings (P/E) ratio of just 12, stunning returns on capital, a debt-free balance sheet and — most importantly — a forecast yield of almost 4.7% for 2017, those looking for income may want to take a closer look at the Bradford-based business.

An alternative to Safestyle might be Headlam (LSE: HEAD). The £414m cap supplier of floor-covering products might not set pulses racing but — bar a slight wobble in 2013 — earnings have grown consistently over the last few years. While operating margins for this kind of business are understandably low, Headlam’s returns on capital are regularly in the mid-teens, underlining its status as a safe and steady performer. It has excellent levels of free cash flow and, with no net debt, possesses a sufficiently robust balance sheet. Trading on a very reasonable P/E of 13 for 2017, shares in Headlam come with a tempting forecast yield of 4.7%.  

Finally, there’s Hostelworld (LSE: HSW). When I last looked at this company back in August, shares were trading at 166p. Since then, they’ve jumped as high as 243p — not bad if you’re simply looking for a capital return. Those who invest for income may want to hold on or continue building a position, however. Based on estimates for 2017, shareholders in the Dublin-based hostel-focused booking platform will see a cracking yield of almost 5.5%. With a forecast P/E of 14, those considering this hugely cash-generative stock will also be getting access to these dividends at a decent price. 

Got it covered?

Finding companies offering decent dividends is just one half of the challenge facing income investors. After all, a chunky payout means nothing if it can’t be sustained (as many holders of FTSE 100 stocks have found out to their cost). This is why it’s vital to look at the level of dividend cover before clicking the ‘buy’ button.  

A company’s dividend cover is simply the ratio of its net income over the dividend paid. It’s calculated by dividing earnings per share by the dividend per share. For payouts to be safe, cover really needs to be as high as possible (and certainly more than 1). With cover at 1.74, 1.59 and 1.28 respectively, the dividends from Safestyle, Headlam and Hostelworld all look relatively safe for now.

One cautionary note. While small companies can be more nimble and financially disciplined than larger businesses, their size also means that they can come unstuck in economic crises. That’s why it’s vital to diversify your portfolio across a number of firms in different industries and markets.  

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Paul Summers has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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