Dividend payouts are a strong indicator of a solid company

Interest rates have been absurdly low for years and look like they’ll stay that way for some time to come. Bank deposits typically pay peanuts and a higher-rate taxpayer gets the princely return of 1% from buying a ten-year gilt. So it’s only natural for investors to look at equities as a way of generating income.

That often means buying blue chips in sectors like utilities, oil, tobacco and telecoms. Stocks like Shell, Vodafone, British American Tobacco and National Grid are all worthy businesses and pay out generous dividends. That’s because they are mature long-established companies, which generate surplus cash flow. I won’t knock them for being big and slow-growing. They can play an important role in many investors’ portfolios.

However, our focus in Penny Sleuth is at the other end of the spectrum. Our micro-cap growth shares are near the beginning of their corporate journeys. They tend to consume cash and often need fresh injections of capital. So for most of them, paying a dividend won’t be on the agenda for a few years.

But there are some smaller growth companies in my Red Hot Penny Shares portfolio that do actually pay a dividend. Obviously, they’re profitable and are much further into the commercial phase of their development than a more speculative early stage company. They also tend to be businesses that generate cash, despite being high-growth.

Even if the dividend payout is a relatively small portion of a company’s earnings, it’s still a valuable thing. And not just because of the little it adds to shareholder returns.

I think the main benefit of small growth stocks paying a dividend is that it acts as a signal of their quality.

Always check if your company pays a dividend

Company accounts can be misleading. Many companies go bust despite reporting profits. They just run out of cash! Profits don’t necessarily equal cash.

So a company that pays a dividend is making a powerful statement. It’s saying that the profits being reported have enough cash behind them to enable a payout to shareholders.

Investors also hate dividend cuts; so a company will make sure it pays out an amount that is sustainable and capable of growing.

These companies that are in a strong-growth phase, but are also cash generative are rare beasts. We might end up paying a premium valuation for them; but we know we’re getting quality.

However, for many small companies, it simply isn’t possible to pay out a dividend. They need to keep investing heavily in order to grow. They might be making profits, but everything has to be ploughed back into the business to support the next stage of growth. There’s nothing wrong with this. It just means they are not as wonderful an enterprise as those cash-generative and dividend-paying growth stocks.

Unfortunately, some companies do like to hang onto cash. Even when they’ve moved well beyond the point when paying a dividend is a sensible thing to do. Management might arrogantly believe they can use the money better than their investors can – or that paying a dividend signals they’ve become mature and ex-growth.

However, Apple’s example shows a top-quality business can grow dramatically while paying dividends.

I apply these principles when filling up my Isa

Apple has become the most valuable company in the world and recently announced the largest ever quarterly profit. At the same time, it pays progressive dividends and has returned cash to shareholders via a massive buyback programme.

We all recognise Apple as a truly great company of our times. It doesn’t just grow, it throws off cash and dividends in the process.

At the other end of the size scale, applying the same principles will point us in the direction of quality small-cap growth stocks. A regular, growing dividend says something positive about the company and about management’s attitude to rewarding their investors.

I apply these principles when I’m investing in my Isa. I like to focus on smaller companies, but I want to make sure my Isa allowance isn’t squandered by being too speculative. So I aim for quality. And a good proxy for quality is the ability to pay a dividend while still being a small, growing business.