What I've noticed over the last four years of investing is that many of the popular companies that us dividend growth investors focus on tend to be large, established companies. And for good reason! These companies typically have enduring, wide economic moats due to decades of hard work building brands, increasing quality, establishing distribution networks, and selling products to the masses - thereby making sure consumers are intimately familiar with what they sell. Economic moats aren't built overnight, and typically you have to have a large castle to warrant a large moat. This means having high quality products that people are willing to pay a premium for.
However, not all great investment opportunities are with large, established companies with decades of dividend growth. While I would always argue that one is best building the core of their portfolio around companies that fit this profile - companies likeJohnson & Johnson (JNJ) and The Coca-Cola Company (KO) - I also think once a portfolio is of sufficient size it might make sense to take a little risk on a smaller company with perhaps more growth opportunities.
Many investors point to the law of large numbers as reason enough to look earnestly for opportunities in smaller, more nimble companies. After all, it makes logical sense that it should be easier for a small company to grow faster than a large company. The problem is that small companies typically have different risk profiles. It's obviously much easier for a $500 million company to go bankrupt than it is for a $50 billion company. So as I pointed out above it's important to be aware of this risk and invest accordingly.
Today, I'd like to point out one small company with a solid entry yield and burgeoning dividend growth record that has the potential to one day become a big company.
Orchids Paper Products Company (TIS)
TIS is a paper products manufacturer, including paper towel, napkins and bathroom tissue. It produces products for private-label per its clients specifications, or under its own brand names - including Colortex, My Size, Velvet, Big Mopper and Linen Soft among others. The company was formed in 1998.
TIS mainly sells its products to dollar stores in hopes to catch the value conscious consumer. Whereas TIS doesn't operate under the assumption that its brand names have any particular recognition or strength, it hopes to make up for that in price and value alone.
Hence, TIS has a strong relationship with discount retailers. Dollar General Corp. (DG) and Family Dollar Stores, Inc. (FDO) together account for 62% of the company's sales. Wal-Mart Stores, Inc. (WMT) is the third largest customer, accounting for approximately 12% of the company's sales in 2012.
Growth has been fairly strong over the last few years. Since 2008, EPS has grown by a compounded annual rate of 10.8%. Net income is up by almost 100% over this time frame, but revenue has grown at a slower pace by only 2.9% annually. TIS continues to operate under a favorable debt structure, with a current debt/equity ratio of only 0.2.
What's especially attractive here for a dividend investor is the current high entry yield at 4.53%. The payout ratio is a bit concerning at 91.5%, but one would hope that growth in underlying operations would allow the growth of the dividend to be sustainable over the long term. The dividend growth has been particularly impressive over the last few years. The company initiated a dividend in 2011, and has grown it from $0.10 per quarter to the current payout of $0.35 per quarter. That's a CAGR of 87% over the last two years. Obviously, we're not looking at a lengthy track record like many of the major companies that make up the bulk of my portfolio, but every record has to start somewhere.
TIS shares are currently trading hands for a P/E ratio of just over 20. That's at the upper range of what I'm usually willing to pay for a stock, but it's a bit interesting here for TIS. What you have is a a small-cap stock trading for the same P/E ratio as many large-cap stocks like PepsiCo, Inc. (PEP), but with theoretically more potential growth due to its small size. It's almost as if it's a growth stock and a value stock all rolled up into one, with a hefty dividend as icing. It's really an interesting play.
I valued shares using a Dividend Discount Model analysis and used a 10% discount with a 7% long-term growth rate, which is comfortably below the EPS growth rate over the last five years. This gives me a fair value on shares of $50. Seeing as how shares are currently trading for just under $31, there appears to be a margin of safety here. However, one must keep in mind that this is a very small company with a relatively short operating history. So the risk is amplified.
Overall, I like what I see with TIS. I can see a spot for a small company like this in my portfolio now that I have a large base of large, strong companies with enduring competitive advantages. Furthermore, I can see the demand for private-label and value priced paper products continuing. No matter your income level, you need to have bathroom tissue. However, the high payout ratio and short operating history gives me pause for now. This is a company I'll continue to watch.
How about you? A fan of small cap-dividend payers like TIS?
Full Disclosure: Long JNJ, KO, WMT, PEP
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