Over the past few weeks, I have been increasingly looking into smaller companies as I believe the valuations on offer in this sector are far more favourable than those of larger companies at present. Most big blue-chip companies – the ones I prefer to invest in – have seen their valuation stretched as the big institutional investors continue to pour money into them and have largely shunned small-cap stocks. This has provided an opportunity for small investors like myself to exploit. Below is a bit of a background of this opportunity and why it has come about.
Over the past couple of decades, economic expansion as a result of globalisation and the rise in corporate profit margins led to an extraordinarily favourable environment for corporate profitability and cash flow growth. Conversely, the deflationary effect of cheap imports more than offset the inflationary pressures of the extra growth, so inflation has remained benign for decades. With inflation low, policymakers progressively lowered interest rates to combat this. This lead to a remarkable reduction in UK bond yields, with the annual yield on UK government debt falling from 10% in 1992 to just 1% currently. Lower bond yields tend to drive up the valuations of nearly all assets. UK house prices have risen tremendously over recent decades, whilst equity markets have also delivered outstanding returns.
However, the ‘emergency’ reduction of interest rates after the Global Financial Crisis in 2008 has led to an unsettling side effect. Many larger quoted companies are finding their market valuations are worth more if they divert capital away from improving corporate productivity towards paying extra dividends instead. The point is that many investors are investing in ‘bond proxy’ stocks because bond yields are so meagre. The indirect effect has been a flat-lining of productivity improvement, which ultimately will undermine the scope for ongoing dividend growth from equities in future. Furthermore, looking at any market index or mutual fund, it is noticeable that
This is where the opportunity for investing in small caps comes in. Many investors today have shunned small caps as they do not offer a high enough dividend yield to invest in. But these companies are doing the right thing by not paying a high proportion of their free cash flow as dividends but instead using it to make productivity gains.
As I have constantly written on this blog, one of the main drivers of long-term returns is the sustained growth of dividends over time. This is typically funded from the cash flow generated on corporate capital investment. For this reason, it is really important that investors prioritise investing in companies that are generating productivity improvements. At times when economic prospects are more muted, there are fewer opportunities for capital expenditure. Therefore, many large PLCs have redirected their surplus cash flow to fund additional dividends for now. This explains why dividend cover, a measure of the sustainability of equity dividends, has declined to unusually low levels for many of the FTSE 100 companies. This implies that the prospect for dividend growth is more limited going forward, along with higher risks of dividend cuts in the event of an economic setback.
Productivity improvement is the foundation of wealth generation. This is because the most productive companies often take additional market share at premium profit margins. It is the rising cash flow that comes from a combination of sales growth and an attractive margin that leads to a rise in equity value over time. Thus, investors need to pay attention to companies that are well placed to increase productivity.
Further as well as offering greater potential going forward as a result of investing for the future, small caps are also at present more attractively valued than their larger counterparts. Many small caps with excess cash on their balance sheet are trading at P/E of below 15; and when you adjust for cash, the real P/E are under 10. You will not find these opportunities in larger companies where the majority of investors are focussing on today.
Small-Cap Income VS Growth Stocks
As mentioned above, many small stock companies are focussing on productivity improvement in order to generate long term wealth. And just because these companies are using their cad flows to fund these improvements, it doesn’t mean that they have no money left over to pay dividends. Many small-cap stocks are producing a decent amount of cash flow which they are using to fund innovation and improvement as well as pay a dividend. And as regular readers will attest, I prefer companies that pay a dividend.
It has been provided time and time again that over the long term, dividend-paying stocks have outperformed the market indices. This appears slightly counter-intuitive as the share prices of income stocks stand on yield premiums because their investors are not enthused by their growth prospects. Those with more exciting growth prospects are normally on more demanding valuations because fast growth is often equated with an expectation of better potential returns.
However, those with higher growth expectations have the disadvantage that they need to keep reporting ongoing premium growth as, when they disappoint, their share prices can fall back sharply. In contrast, income stocks often come with low growth expectations embedded in their valuations and, providing they maintain their dividend, their share prices tend to be less vulnerable to setbacks.
The extra value that arises from the cumulative dividends on income shares tends to generate a better return than the extra share price appreciation that comes with growth stocks. Therefore, over the longer term, income stocks have tended to outperform growth stocks. This is most apparent at times when more growth stocks suffer share price declines because they fail to meet the high growth expectations baked in to their share prices. This is why I favour income stocks over growth stocks.
My Purchase Of Creightons
Creightons PLC is a manufacturer of high-quality personal care and beauty products for the consumer and trade market. As well as owning its own brands, Creightons also manufactures products for other companies (namely store brands) which adds to the diversified stream of income the company generates. Furthermore, the company’s products cater to different market segments as seen from the different retailers which stock their products; from Poundland to Harvey Nichols.
Being a small company, Creightons has grown substantially over the past decade. Over this period, the company has gone from 3 brands to 10 brands, 1 private label customer to 9, 2 discount brand customers to 20+, 10 contract customers to 30+ and 0 export markets to 30+. This is the type of growth I like to see in the companies I invest in.
From an investment perspective, the company ticks a lot of boxes for me. It’s in the consumer staples sector which I like. It has a strong balance sheet. It has sound financials with decent operating margins of about 6%. It is growing at approximately 20% a year. It has a 10% return on capital employed figure which has been increasing over time. Insiders have a significant shareholding in the company And it offers great value with a P/E under 15.
I purchased 2,298 shares in Creightons for a price of 29.5p a share last week. It was a weird purchase so to speak as I bought the shares in the morning and by the close of the day, I was already down 5% as the share price was dropping like a stone. I actually panicked a little as I wondered whether I made the right decision buying into the company. Thankfully, the price rose substantially over the next day and eased my nerves. This is a lesson when investing in small caps. Companies like Creightons are very illiquid and thus their share prices are way more volatile than larger companies whose shares are more liquid.
Creightons pays a dividend of 0.38p a share. So for my 2,298 shares, I expect to receive £8.73 in dividend income a year. The dividend paid by the company is well covered so I expect this figure to rise substantially in the years to come. The dividend from Creightons also edges me closer to getting £2,000 in annual passive dividend income.