Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
As the weather gets colder and I get older, I've begun to enjoy the comfort provided by a warm bowl of soup. There's nothing like a delicious mix of vegetables and chicken to ward off the chill in the air.
As I sat down to my first bowl of the season my thoughts turned to how I might pay for my humble repast for years to come. A few good dividend stocks might do the trick.
Problem is, a steady dividend payer doesn't really fit the bill because the cost of soup has the tendency to rise over time. More precisely, the purchasing power of the dollar has a nasty habit of declining due to inflation. That's why I prefer companies that increase their dividends. The best show a pattern of growth over the past five years and, preferably, over the past year.
While many investors love large dividend payers, smaller firms have room to expand their businesses, which can make them more attractive. But they also come with some risks, which is why it's wise to demand a measure of safety from the small fry.
A firm's debt rating represents one measure of stability, but such ratings are often unavailable for small firms. However, you can brew your own according to Professor Aswath Damodaran of New York University. He observed that debt ratings are highly correlated with interest coverage ratios. If you know a stock's interest coverage ratio then you can get a fair idea of the rating it should have.
Interest coverage ratios themselves are calculated by dividing a company's earnings before interest and taxes by its interest expense. A low ratio indicates the firm might have trouble paying its debts, which would lead to a low debt rating. A high ratio suggests the company has a large margin of safety and likely deserves a high rating.
For small companies, Prof. Damodaran suggested an interest coverage ratio of four or more was roughly equivalent to a debt rating of BBB of higher. It seems like a good requirement to me.
Dividend investors are also wise to examine a firm's earnings. After all, companies that pay more in dividends than they earn will eventually be forced to cut their dividends. In an attempt to avoid such calamities, I stuck to stocks that earn more than they pay out.
In addition, I never want to pay too much for a stock. That's why I'll follow the lead of famous value investor Benjamin Graham, who thought investors should avoid companies trading for more than 20 times their earnings.
Four small Canadian stocks that pass all of these tests, according to S&P Capital IQ, are Logistec Corp. (LGT.B), Glentel Inc. (GLN), Andrew Peller Ltd. (ADW.A) and Airboss of America Corp. (BOS).
Of the bunch, Glentel of Burnaby, B.C., caught my eye. The firm sells mobile phones and related services in Canada, the U.S., and Australia. Roughly 54 per cent of its quarterly sales were generated in the U.S., 31 per cent in Canada and 13 per cent in Australia. The rest was picked up by its business services division.
Bargain hunters will appreciate the firm's low price-to-earnings ratio of 12 and modest price-to-free-cash-flow of 6.5. Income investors will note its dividend yield of 3.4 per cent. In addition, its dividend growth record has been superb. Back in 2007 the firm paid 15 cents a share to investors, climbing to 45 cents a share in 2012. This year the company is on track to pay 50 cents, not including the special dividend it usually sends out in November.
With a bit of luck, Glentel, which closed unchanged at $14.50 on Friday, will pay for more than a few bowls of soup for some time to come.
Norman Rothery