Screening Small Cap Dividend Growers for Returns

NEW YORK ( TheStreet) -- I've long been a believer that dividends represent more than just cash that is returned to shareholders; more than just yield. We all know that there are things companies can do that can fool investors, which may or may not be the intention. They can manipulate their earnings, they can announce stock buybacks, and never follow through, but they can't manipulate their dividends.

In my view, when companies raise their dividend year in and year out, it can be a good indicator not only of financial health, but also of confident management. This is also something that cannot be faked, for very long anyway.

Companies that raise their payouts to the point of unsustainability ultimately risk having to cut their dividends, which is rarely, if ever, viewed positively by the markets. In a way, this creates a system of checks and balances.

The past couple of years I've run a stock screen early in January designed to identify smaller companies that not only have a strong record of dividend growth, but also appear to have the ability to continue raising their dividends in the future. The level of yield here is not of great concern to me, and this is certainly not an income generation strategy.

The search criteria that I employ for this strategy includes the following parameters:
  • Market caps between $500 million and $2 billion
  • Dividend increases in at least each of the past five years
  • Long term debt to equity ratios less than 50%
  • Dividend payout ratios less than 50% for the trailing 12 months, and last two fiscal years

Last year, 28 companies made the cut, and the average performance of this somewhat well-diversified group of names was decent, up 13.3%, versus a gain of 12.3% for the S&P 600 Small Cap Index, and 12.25% for the Russell 2000. The prior year 18 names met the criteria, and the performance for that group was very similar, up 13%. However, outperformance relative to the Russell 2000, which was down 0.6%, and S&P 600 Small Cap Index, which was up 4.3%, was much greater.

Water heater manufacturer A.O. Smith ( AOS) was the best performer, up 53%. Irrigation equipment manufacturer Lindsay ( LNN), also performed well, up 45%, followed by West Pharmaceutical Services ( WST) up 42%, and Stepan ( SCL) up 40%. Overall, 22 of the 28 names were in positive territory during the period. AOS Chart AOS data by YCharts

The worst performers were Raven Industries ( RAVN) down 17%, and Monro Muffler and Brake ( MNRO), down about 9%. The only other names in negative territory were Sensient Technologies ( SXT) down 6%, Men's Wearhouse ( MW) down 6%, and Republic Bancorp ( RBCAA) down 5%.

While relative outperformance was not spectacular last year versus the indices, this screening technique is worth repeating, at least in my view. I'll be developing a new list of names that meet the criteria, which I'll publish in the near future.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.