5 Small Stocks That Pay Big Dividends

As an income investor, I occasionally feel forced to choose between growth and a hefty dividend. Finding a high yielding stock that also has good growth potential is a rarity. One reason for that may be that fast-growing companies often don’t pay a dividend. Instead, these companies re-invest their cash flow in the business and only begin paying a dividend when internal growth prospects diminish.

While it is generally difficult to find income and growth in the same investment, there are a handful of exceptional stocks that manage to combine both. These rare gems do exist, but the trick is knowing where to look. 

A good place to start is in the universe of small cap stocks. That is because small companies typically grow faster than big companies. They also perform better coming out of a recession. That pattern is evident in this economic recovery. The  S&P 600  Index of small cap stocks is up about 28% in 2010 after returning 25.6% in 2009. That’s more than triple this year’s 13% gain of the well-known S&P 500 Index of large companies. 

Small cap outperformance didn’t suddenly begin with the current bull market. In fact, small cap stocks have led the market for more than a decade. Since the end of 1999, small cap stocks have delivered annualized gains of 3.9%, compared with losses of 0.5% for large stocks.

A screen for small cap stocks was my starting point for finding high yielders that are still growing. I then screened this group for names with generous yields and above-average income growth. Here are the top results from my search.

1. Fifth Street Finance Corporation (NYSE: FSC)
Yield: 11%
Business development companies (BDCs) like Fifth Street make loans to small companies, often taking an equity stake as well. More importantly, BDCs pass along the majority of income earned from these investments to shareholders, allowing them to pay great yields for aggressive investors — many currently yield 8% to 11%.

Fifth Street is benefiting from renewed merger and acquisition activity this year and has signed a record level of new deals totaling $211 million in the December quarter. Per share earnings doubled in the fiscal year ended in September. Income from investments rose by 31%. Fifth Street pays dividends monthly at an annualized rate of $1.28. The stock is up 15% in 2010 and has outperformed the S&P’s 13% return.

2. Martin Mainstream Partners LP (Nasdaq: MMLP)
Yield: 8%
Martin provides natural gas gathering, storage and transportation services for independent oil and gas producers. This limited partnership recently recorded one of its best quarters ever for its transportation business, which is involved in cleanup efforts in the Gulf of Mexico following the BP (NYSE: BP) oil spill. Martin has hiked cash distributions every year since 2003 and currently pays a $3.00 dividend. Cash flow of nearly $44 million so far this year has amply covered $42 million in dividend payments.

Martin’s shares have returned 26.7% this year — more than twice the S&P’s return. Consensus analyst estimates look for earnings to improve about 55% in 2011. 

3. Great Northern Iron Ore Properties (NYSE: GNI)
Yield: 11%
Great Northern owns more than 67,000 acres of mineral leases on the Mesabi Iron Range in northeastern Minnesota. This royalty trust is benefiting from increased mining of its leases due to rising steel demand and higher royalty rates. Net income for the September quarter jumped nearly five fold year-over-year, from $1.3 million to $5.2 million.

Great Northern’s 11% yield is among the highest in the mineral trust segment. Annualized distributions have increased from $10.25 five years ago to $12.25 today. Cash flow more than covers dividend payments.

Great Northern’s shares have returned an average of 9.1% annually in the past five years, but are up 47% in 2010. Investors should note, however, that the trust has a finite lifespan and dissolves in April 2015. On that date, investors will receive a final distribution amounting to the liquidated value of the trust.  

 4. Triangle Capital Corporation (Nasdaq: TCAP)
Yield: 9%
This BDC specializes in the low end of middle market lending, typically investing in businesses with annual revenue of less than $100 million. Triangle has enjoyed a steady stream of new portfolio investments, which has produced a 40% gain in investment income this year. Consensus analyst estimates target 8% earnings growth next year.

Triangle has paid 16 consecutive quarterly  dividends since its public offering in 2007. The company also raised quarterly  dividends 2.4% in December to a $1.68 annualized rate. Triangle’s dividend payout is comfortable, at 82% of earnings. The stock has also been a stellar performer this year — shares are up nearly 57%, more than four times the S&P’s return. 

5. Knightsbridge Tankers, Limited (Nasdaq: VLCCF)
Yield: 10%
Bermuda-based Knightsbridge owns supersized, ocean-going cargo vessels that transport oil and bulk commodities. This company’s operating cash flow has doubled this year and it recently raised $88 million through a public offering, which will be used to pay down debt and acquire more ships. Cash flow of $49.6 million this year easily covered $21.2 million in dividend payments. These

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