Three small-cap stocks with big payouts

Small-cap stocks are beginning to offer investors higher income. Fund manager Scott McKenzie tips three such London-listed stocks to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now.This week:Scott McKenzie, fund manager, Saracen UK Income fund.

For much of my career managing equity income funds, the majority of small-cap stockshave had little interest in paying out significant dividends. Most have focused on reinvesting and growing their businesses instead.

As a result, income funds have for many years relied on a small number of large companies to do the heavy dividend lifting for them. But this is changing increasingly, smaller companies recognise the importance of offering investors a high and growing income, while still ensuring that their businesses are properly funded.

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When we assess dividend coverfor the UK market overall, there has been a sharp fall in the past two years. This is due to deteriorating cover levels among the largest companies, and increasing dividend payout ratios across the wider market. We believe that dividend prospects for medium-sized and smaller companies now appear far brighter, reflecting the generally higher exposure that such businesses have to a UK recovery.

So when we launched the Saracen UK Income fund recently, much of our research efforts went into finding smaller, growth companies offering secure, growing dividends over the longer run, funded by sound balance sheets. Some are older businesses undergoing strategic change, others are newer entrants to the markets.

STV Group (LSE: STVG) is a small media business that operates the ITV franchise for Scotland and has interests in content production as well as a strong digital presence. It has changed course markedly over the last few years, selling a number of disparate businesses that had got it into trouble, to focus purely on TV.

Once-dangerous levels of debt are now under control and the business is well placed to benefit from improving advertising trends and the launch of further digital services. STV is now committed to growing its dividends significantly, having spent many years in the wilderness. The stock's current low rating gives it no credit for this.

FDM Group (LSE: FDM) is an IT services provider supplying entry-level staff to help clients run "business-as-usual" functions. The company listed last July and has just delivered its first set of full-year results. The business model revolves around training and selecting high-calibre graduate recruits who are seeking a route into a career in IT and business management.

The company now has £12m net cash. The dividend prospects are excellent, with positive cash conversionand low capital spending a feature of its business model. FDM offers investors a healthy starting yield of more than 4%, with potential double-digit growth from here. Special dividends may also be possible within a few years, with growth expected to be largely organic.

Eurocell (LSE: ECEL) makes and distributes PVC building products for windows and roofing. It listed in March this year. Around 50% of the goods it sells are manufactured in-house. The business occupies strong niche positions: it's the number-three manufacturer of window profiles (a key component), the biggest player in roofing, and the largest distributor of such products by a long way. It has 130 branches and its mid-term goal is to have around 250 in what is a fairly specialised niche.

Debt will fall rapidly and dividend prospects are strong. While it is early days for Eurocell as a quoted company, the management team has been with the business for some time and is supported by a strong non-executive board.

Scott McKenzie is fund manager of the Saracen UK Income fund.