If you’re looking to build a well-diversified portfolio of dividend stocks, I think it’s important to look beyond well-covered blue chip names for the best investment opportunities. This is because by looking further afield, income investors will be able to substantially widen the range of their investments.
Concentration of stocks
Only a handful of FTSE 100 companies account for a near-majority of the index’s total dividend payouts, meaning there is a very high concentration of stocks at the top of the market. Meanwhile, the number of small-cap companies paying dividends to their shareholders has been on a steady rise in recent years. Although many of them fly under the City’s and investors’ radars, there’s growing interest in small-cap dividends from income-focused investors.
With this in mind, I’m taking a look at two high-yielding small-cap shares that seem set to continue rewarding their shareholders generously.
Wide economic moat
When it comes to finding reliable dividend stocks, I think one important question to ask is: does the company have a wide economic moat?
Few things are as important to a company as the ability to keep rivals at bay. Companies with wide economic moats usually stay ahead of the competitors over a prolonged period due to sustainable competitive advantages which make it difficult for rivals to wear down their market share. For that reason, companies with wide moats tend to generate steady, dependable profits year-after-year which, in turn, enables them to pay reliable dividends over the long term.
One example of a wide moat company is payments service provider PayPoint (LSE: PAY). With nearly 50,000 PayPoint terminals operating in the UK, Ireland and Romania, the company has a weighty market presence in an industry where scale is paramount.
Clients, ranging from utility and media companies to government organisations, prefer to use a single cash payments solution, and so too do customers, for ease of use and convenience. Moreover, the very high-fixed costs required to set up a competing network throws up significant barriers to entry. That makes it difficult for competitors to break into the market and allows PayPoint to dominate the market.
Shift to online payments
PayPoint’s long-term worry, however, is the shift towards mobile and online payments — fast-growing markets which the company has, so far, struggled to make significant headways into. Revenues for UK cash bill payments & top-ups are plateauing, meaning Paypoint has a need to find new sources of growth.
The company is doing better in the parcel business, with its Collect+ ‘pick up and drop off’ service seeing strong growth. Parcels are also proving to be a valuable complementary service for its core payments business, driving extra footfall into its convenience retailers and generating revenue synergies.
Meanwhile, Paypoint continues to innovate to maintain its competitive advantage. The deployment of its new ‘PayPoint One’ touch-screen retailer terminal continues apace, with the company seeing healthy growth in the average weekly service fee for sites which have adopted the new terminal.
On the downside, the roll-out of PayPoint One, along with other investments in MultiPay and customer service, will add significantly to its cost base, depressing margins and its bottom-line performance in the near term.
However, I reckon this is a classic case of short-term pain for long-term gain. Following a predicted 1% dip in adjusted earnings per share for the current financial year, City analysts forecast earnings to rebound by 6% in the 2019/20 financial year.
And despite big investment costs, free cash flow is expected to remain resilient, enabling the company to maintain its progressive dividend policy and return additional surplus capital via special dividends.
Paypoint has a current dividend yield of 4.8%, but this rises to 8.7% when we include additional dividends for the total payout in the year. And when you chuck in a forward P/E ratio of 15.4 times into the equation, valuations seem very tempting indeed.
Weak market backdrop
Elsewhere, shares in Headlam Group (LSE: HEAD) have been under the cosh of late due to the soft UK floorcoverings market affecting revenue in both the residential and commercial sectors.
These pressures caused an uncharacteristic revenue slip in the UK for the six months to 30 June, which declined by 0.5% compared with the prior year period. On a like-for-like basis, things looked even worse, with the UK showing a decline in sales of 5.5%.
Still, Headlam managed to weather much of weak UK trading conditions via a well-timed strategic acquisition and management initiatives to prioritise margins. Gross margin across the group improved by 103 basis points to 31.06% in the six-month period, while total revenue increased by 2.6% to £337.2m.
The company, which is Europe’s largest distributor in its sector, has achieved this margin improvement through the streamlining of internal processes and a warehouse reconfiguration to improve capacity and delivery efficiency.
Despite the soft market, further gains could be on its way as Headlam continues to focus on margins and drive top-line growth via acquisitions.
Shareholders often get nervous when companies rely on acquisitions to deliver growth, because of the impact on financial leverage and the potential pitfalls of mergers. However, Headlam has changed the way it approaches acquisitions, with its new strategy aimed at diversifying and broadening the company’s overall position in the floorcoverings market.
It’s looking to further strengthen its market-leading position by seeking targets that improve its sector presence, bring strategic benefits, or further geographic coverage. Headlam has in place a disciplined approach and has net cash of £35.3m at the end of the last financial year.
Looking ahead, City analysts expect earnings to hold up well, with adjusted EPS forecasted to climb 2% this year. This should be followed by a further 5% growth in 2019, driving adjusted earnings to 44.6p per share.
What’s more, the combination of steady earnings growth and a healthy balance sheet is expected to drive robust dividend per share growth, predicted to expand to 27.4p by the end of 2019. As such, this suggests Headlam’s dividend yield is expected to rise from 4.2% currently, to as high as 5.9% within the next two years.
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Jack Tang has no position in any of the shares mentioned. The Motley Fool UK owns shares of PayPoint. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.