How to hunt for the best dividend shares on AIM this ISA season

(Before It's News)

The value of the Alternative Investment Market has risen by 30% over the past 12 months. That sort of stellar performance is likely to appeal to investors looking for a home for ISA funds this year. But while AIM has numerous attractions, it’s still a potentially risky source of investments. One way of overcoming that is to focus on the market’s better quality dividend paying shares.

Neil Woodford, the popular fund manager, recently wrote that there’s no other piece of information like the dividend that could more accurately reflect what a business really thinks about its current state of health.

For Woodford, the “walk of shame” of cutting dividends is enough to deter most executives from doing so wherever possible. Moreover, those that ratchet up their payouts do so knowing that they’re creating a bigger burden for themselves in the future. So they need to be confident that dividend growth is sustainable.

The appeal of AIM income stocks

AIM was designed to be a market for smaller, growth-oriented stocks. When successful, that can translate into spectacular capital gains for shareholders. But as a consequence, many of these companies are more likely to raise money from investors than distribute spare cash back to them.

But it’s also true that some AIM companies have established themselves as attractive income stocks. When you put that in the context of the market’s tax incentives, there are compelling reasons to take a closer look.

For a start, capital gains and dividends are sheltered from tax inside a wrapper like an ISA (subject to individual circumstances). Plus, there’s no stamp duty payable on most AIM shares, and the majority come with inheritance tax advantages, too.

Around 230 of the 970 companies on AIM pay some sort of dividend. Roughly 110 of them are forecast to yield more than the 2.3% rate of inflation in the next financial year. So how do you begin slicing through these stocks to find some of AIM’s better quality high yielders?

Screening rules for high yield small caps

Income investors tend fall into two camps – those chasing high yield and those chasing long-term dividend growth. But it’s useful to see both of these features in building a picture of an AIM dividend stock. So in filtering the market – using this screen – I’ve looked for a dividend growth streak of at least one year. One year is nowhere near sufficient for most dividend growth investors. But it will pick up any recently listed shares (IPOs), as well as those that are re-introducing payouts after a hiatus.

The 1-year forecast yield rule was set at a minimum of 2.5%, although seven of the top 10 results come in at more than 3.0%. Dividend cover – a conventional dividend safety measure of the degree to which earnings cover the payout – was set at a minimum of 1.2x. In practice, most easily beat that.

Finally, passing stocks had to have a combined Quality amp; Momentum (QM) rank of more than 80. That focus puts us very much towards the “High Flyer” end of AIM, where we’d expect to see companies with good financial strength and positive price and earnings momentum. Both factors are naturally important to income investors looking for sustainable payouts.

But the associated downside of High Flyers is that these shares can be potentially expensive. That’s borne out in the ValueRanks of many of them, with low ranking scores suggesting that investors are having to pay up for good quality dividends on AIM. That’s what you might expect in bullish conditions.

With the exception of James Halstead, these screening rules gravitate towards stocks in the £100m-£300m bracket. Some of the notable points from the list include Numis, the corporate broker, which has the highest forecast yield at 5.0%. It operates in a sector that’s naturally sensitive to the performance of the stock market, but when times are good these types of firms can be very profitable.

Among the higher yields are some of the lowest dividend streaks. Safestyle UK and XLMedia only floated in 2013  and 2014 respectively, yet they’ve so far raised its payouts each year since. Hamp;T, the pawnbroker, cut and held its payouts in 2013 and 2014 but has since hiked its dividends as business conditions have improved.  Note that XLMedia (and Somero Enterprises) report dividends in dollars.

For a slightly lower yield you tend to see an improved dividend streak, with Cello, James Halstead and Mamp;C Saatchi all producing 6-year compound annual growth in their dividends of between 11% and 16%.

Aiming for high yield

While the strong performance of AIM over the past year is encouraging, it’s still a market where disasters can happen. In smaller stocks that are potentially prone to unforeseen setbacks, dividends are likely to be the first casualty if things go wrong – no matter what the directors would like. But despite the inevitable disappointments, there is a slice of the AIM market that deserves attention from dividend investors. These companies can have the capacity to grow and rerate very quickly, which is something you don’t often associate with income investing.

You can find the High yielding quality AIM shares screen here. All of Stockopedia’s model dividend strategies can be found here.

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