One of my favorite places to search for undiscovered income stocks is in the small-cap sector. Most small-cap stocks have few analyst followers and little institutional ownership, because their limited liquidity makes big positions more difficult to unwind. As a result, many good small-cap stocks go unnoticed and can be underpriced, so they're potential bargains for investors willing to do the homework.
Of course, finding reliable dividends in the small-cap sector can pose challenges. Most small-caps lack critical mass, which means a major setback can quickly drain resources or even put them out of business. That's why you should only hold small-caps well-prepared to weather any storm. I look for companies that have low debt and plenty of cash -- these are the type of businesses that can afford to invest in growth while paying dividends to investors.
1. American Science and Engineering (Nasdaq: ASEI)
Dividend Yield: 4%
This company is a leading worldwide provider of X-ray screening equipment and detection devices for homeland security and defense applications. American Science equipment is found at border crossings, seaports, military bases, airports and transportation hubs. Screening safety companies such as American Science will benefit from new Transportation Security Administration rules requiring all air cargo entering the United States to be security-screened starting December. Shipping companies are already scrambling to acquire the necessary technology.
While the company's earnings per share fell 23% in the first-quarter of fiscal 2013 (ending in June) to 47 cents compared with a year earlier because of military budget cuts, American Science reported an impressive four-fold increase in order bookings to $41.6 million compared to $8.3 million a year earlier and 8% backlog growth to nearly $187 million.
Of the five analysts following American Science, four rate the stock a "hold" and one rates it "strong buy." Consensus estimates expect modestly lower earnings this year, but growth accelerating to 15% in each of the next five years. American Science has $174 million of cash, just $5.4 million of debt and conservative payout from cash flow at 28%. Dividends have tripled during the past five years to a current annual rate of $2 that yields almost 4%.
2. Crown Crafts Inc. (Nasdaq: CRWS)
Dividend Yield: 6%
Crown Crafts makes infant and toddler products such as bedding, bibs, cribs, bathing accessories and nursery decor. Its products are sold through big-box retailers such as Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), and specialty stores such as Toys R Us.
Licensing agreements with the likes of Disney (NYSE: DIS), Sesame Street, Looney Tunes and other major brands set Crown Crafts apart from competitors. In addition, the company is pursuing growth through acquisitions, product-line extensions and international sales. During fiscal 2012 ended in April, Crown Crafts improved earnings per share 15% to 52 cents compared with a year earlier and doubled the dividend.
Only one analyst follows Crown Crafts. He rates the stock a "strong buy" and estimates yearly earnings growth of 18% during the next five years. The company has no debt, $4 million of cash and comfortable dividend payout of 40%.
Crown Crafts began paying dividends again in 2010 following a 10-year hiatus at an 8-cent annual rate and recently hiked payments to 32 cents a share. Crown Crafts shares presently yield roughly 6%.
3. Meridian Bioscience (Nasdaq: VIVO)
This life-science company makes diagnostic test kits for common gastrointestinal illnesses, foodborne diseases and respiratory infections. Meridian markets its test kits to hospitals, laboratories, research centers and physician offices worldwide.
Meridian's earnings per share grew 22% during the first nine months of fiscal 2012 to 60 compared with a year earlier, but the company reduced guidance for full-year growth to 16% from 26% because of weaker sales in Europe.
New diagnostic tests for strep infections and whooping cough that will launch next year should improve profits. The consensus estimate among six analysts who follow Meridian is 14% earnings growth in each of the next five years.
Meridian has full capacity available under a $30-million bank line of credit and nearly $28 million of cash. Annual dividend growth has been 22% in five years to a current rate of 76 cents yielding about 4%. Meridian targets payout high at between 75% and 85% of earnings.
4. Electro Rent Corp. (Nasdaq: ELRC)
Dividend Yield: 5%
Electro Rent leases electronic test-and-measurement instruments, personal computers, and servers to Fortune 500 companies in the aerospace, semiconductor, electronics and telecommunications industries. It is the largest lease company in North America and one of only a handful that has a global platform extending into in China and Europe.
Electro Rent's earnings per share rose 8% in fiscal 2012 ended in May to $1.07 compared with a year ago. The one analyst following the company predicts 15% yearly earnings growth during the next five years.
Acquisition spending cut cash from $41 million to $9 million this year, but the company has no debt and $25 million of borrowing capacity. Electro Rent sports a healthy three-year annual dividend growth rate of 20%, payout of just 28% and a generous 4.5% yield.
Risks to Consider: Small-cap stocks often have bigger price swings and three of the four stocks mentioned have betas above 1.0, indicating more volatility than the overall market. The exception is Crown Crafts, which has a beta of 0.69. A risk specific to Crown Craft is its reliance on Wal-Mart and Toys R Us for more than half of its sales.
Action to Take --> My top pick overall is American Science and Engineering because of a strong outlook for the cargo-screening market. Crown Crafts and Electro Rent are also good choices for income investors because of their rapidly-rising dividends and good balance sheets. Meridian is a bit riskier because of its higher payout, but it's priced at a 20% price to earnings (P/E) ratio discount to competitors and 30% below its five-year average P/E.