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Fishing for a bargain among small-fry dividend growers

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 turns colder I'm looking forward to fall foliage, hot apple cider and – especially – the arrival of pumpkin pie. The best pies meld together a lovely blend of spices in an almost magical way.

While I might not be the best baker in the world, I also like to mix together ingredients when hunting for delectable stocks. One combination that works particularly well is looking for stocks that offer both good value and dividend growth. Insisting on value helps to keep the prices I pay in line, while keeping an eye on dividend growth points the way to reasonably healthy businesses.

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When it comes to spotting value, I'm a big fan of the techniques of the late Benjamin Graham. He was Warren Buffett's mentor and a stellar money manager in his own right.

In his classic book, The Intelligent Investor, Mr. Graham pointed defensive investors to stocks trading at moderate-to-low multiples of both earnings and book value (a firm's net assets). He thought stocks trading for less than 15 times earnings and under 1.5 times book value were worthy of consideration.

Neither requirement appears to be particularly demanding on its own, but insisting on both together eliminates roughly 90 per cent of the stocks on the Toronto Stock Exchange from consideration.

While Mr. Graham liked stocks with long records of uninterrupted dividend payments, I prefer a little dividend growth. Responsible companies tend to increase their dividends only when business prospects are reasonably good. Conversely, they often hold off on paying more when times are difficult. Looking for stocks that have recently increased their dividends is usually quite beneficial.

Only about 42 per cent of the companies on the TSX pay dividends. A mere 17 per cent have grown them over the last five years.

Most income investors are keen on large stocks that pay juicy dividends. I like them too. But, today, I'm going to focus in on the smaller fry, which tend to go unnoticed and unloved in the hustle and bustle of the stock market.

More specifically, I'll concentrate on those with market capitalizations (their price per share times the number of shares outstanding) of less than $500-million. Such firms might not be as resistant to adversity as the large guys, but they can be better bargains.

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As it happens, some 66 per cent of the stocks on the TSX pass the small-market capitalization test. The large number of small stocks is a testament to the popularity of junior mining and energy firms in Canada along with other entrepreneurial companies.

However, subjecting this crowd of possibilities to both the value and dividend-growth requirements leads to a very small list of stocks. According to S&P Capital IQ, it includes Accord Financial Corp. (ACD), Akita Drilling Ltd. (AKT.A), Andrew Peller Ltd. (ADW.A), Cervus Equipment Corp. (CVL) and Clarke Inc. (CKI).

Cervus Equipment of Calgary happens to own the largest group of John Deere agricultural equipment dealers in Canada along with commercial and industrial equipment businesses in western provinces. Roughly 65 per cent of the firm's sales are generated by the agricultural sector while the commercial and industrial segments make up the remaining 35 per cent.

Dividend investors will appreciate Cervus's 4-per-cent yield and its habit of regular dividend increases over the last couple of years. The stock also trades at a modest 12 times earnings and 1.4 times book value.

It is worth noting that the firm has grown its book value per share by an average of 20 per cent annually over the last four years. That's a fine record, and analysts expect the company to post higher earnings next year, which should lead to even more book value growth.

With a bit of luck, Cervus will continue to provide a harvest of cash to its shareholders for a long time to come.

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