Three small-cap stocks for a steady income

Investors looking to diversify their income stream are increasingly heading to overseas markets. But investors shouldn't overlook opportunities closer to home, especially in the small-cap sector of the market, says professional investor Ed Beal. Here, he picks three smaller companies that offer both an attractive yield and dividend growth.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Ed Beal, manager of the Dunedin Smaller Companies Investment Trust.

Income investors have a problem. British firms' aggregate dividend payments fell by £10bn to £56.9bn (equivalent to a 15% cut) in 2009, according to Capita. For now, overseas markets appear to be the top destination for investors looking to diversify their income stream. Yet while firms in Asia, Europe and Latin America can offer attractive yields, investors shouldn't overlook opportunities closer to home. In contrast to their blue-chip peers, UK smaller companies have a smoother revenue profile across most sectors. The small-cap universe is also less reliant on individual companies' dividend contributions. The top 15 dividend-payers in the FTSE 100 contribute nearly 70% of the index's dividends, whereas for the FTSE Small Cap index the equivalent figure is just 32%.

It is perfectly possible to construct an income portfolio of small firms without being overly reliant on the top 15 income contributors. Companies I currently favour outside of the top 15, and which offer an attractive yield and also dividend growth, include The Restaurant Group (LSE: RTN), Mothercare (LSE: MTC) and XP Power (LSE: XPP).

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The Restaurant Group has successfully demonstrated the resilience of its business model throughout the recession. Management has been able to use internally generated cash flows to grow the business. Better still, a high level of cash generation has also allowed it to offer an above-average yield while delivering this growth. At its most recent results, the firm reported 5% growth in earnings, a reduction in an already low level of net debt, an acceleration of growth targets and a 4% increase in the dividend. The company trades on a p/e of 12.5 times and has a yield of 3.6%.

Mothercare, meanwhile, enjoys excellent brand recognition, with 95% of first-time mothers visiting a store. It has continued successfully developing its business through the acquisition of the Early Learning Centre and the development of a multi-channel distribution capability that is some way ahead of the competition. Growth from the company's overseas operations has been particularly pleasing.

The move overseas has been executed using a low-risk approach. Mothercare only recently established a direct presence itself in order to compliment royalty-based sales to franchisees. The strength of the brand has been evident in these markets and the overseas operations now contribute nearly half of the group's profits. This, combined with a strong balance sheet, has allowed Mothercare to increase its dividend by almost 20% at its last results.

My final tip, XP Power, has spent the last few years investing in its product pipeline while also improving the underlying quality of the existing business. Margins have expanded significantly and growth in new product sales looks set to accelerate. The firm has also successfully increased the number of products that it develops itself. Meanwhile, the head office has been relocated to Singapore and the group has built its first Chinese manufacturing facility. Despite being hit by the recession, the firm still recently reported record earnings per share and a near 5% increase in the dividend. It trades on ten times earnings with a 5.2% yield.

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The stocks Ed Beal likes

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The Restaurant Group234.40p125p229.20p

Ed Beal is the manager at the Dunedin Smaller Companies Investment Trust. Ed has contributed to MoneyWeek in the past, giving his outlook on share tips.