While large blue-chip dividend growth stocks enable investors to sleep well at night and enjoy the benefits of attractive risk-adjusted long-term compounding, smaller cap stocks have the potential to deliver exceptional total returns as they generally enjoy much greater growth potential and often offer higher dividend yields as well.
Below, we will cover three small-cap stocks that we think offer attractive total return potential.
Bulk Up on This 'Slim Down' Name
Medifast (MED) is a weight loss and nutrition company based in Baltimore, Maryland. They operate through their health and wellness community called OPTAVIA, which offers exclusive nutritional products through nearly 60,000 independent coaches. These coaches earn commissions for marketing and selling OPTAVIA products to their clients. The OPTAVIA brand accounts for 98% of the company's revenue, which is why they focus on increasing the number of coaches promoting their brand.
Medifast has achieved a 35.6% compound annual growth rate (CAGR) in earnings per share over the past nine years. The increase in independent coaches within the business has driven this growth, with 60,900 coaches today compared to 12,500 in 2016. However, inflation and rising costs have weighed on the company's growth in the latter half of 2022.
Medifast has a large potential market, with over 42% of Americans suffering from obesity. However, due to the cyclical nature of the business and increased costs, the EPS forecast has been downgraded to 3% annually through 2028. First-quarter 2023 EPS guidance is between $1.75 and $2.40, with an estimated FY 2023 EPS of ~$9.60. The company has a solid dividend policy, with an average 34% increase over the last five years, but a more conservative approach predicts a 5% increase, targeting $8.37 per share by 2028.
Medifast's main competitive advantage is its doctor-developed program for fast, safe, and sustained weight loss, which has been backed by over 20,000 doctors since 1980. The company claims an 86% retention rate due to this program. However, the weight loss industry is highly competitive, with a low entry barrier and constantly evolving trends and products. Medifast's business model relies heavily on increasing the number of coaches, who advertise and sell the company's brands to friends and family, with a decline in coaches potentially leading to a sharp decline in revenue.
With a 6.4% dividend yield, a forecasted 3% EPS CAGR, and an expected 7.1% annualized tailwind from valuation multiple expansion, MED is poised to deliver exceptional 16.5% annualized total returns over the next half decade.
Green Mountain Dividends
Ethan Allen Interiors (ETD) is a vertically integrated interior design company that sells home furnishings online and through its network of approximately 302 design centers. The company generates 84% of its sales from its Retail segment and 16% from its Wholesale segment, which includes sales from independently owned stores.
Ethan Allen suffered during the pandemic due to the closure of its service centers but recovered quickly thanks to pent-up demand and fiscal stimulus packages. The company is positioned to continue benefiting from long-term work from home trends and follows a build-to-order business model customized to the customer's preference.
The company has enjoyed an average annualized growth rate of 12.9% in EPS over the past nine years. However, EPS is expected to fall slightly to $3.50 in 2023 as excess demand subsides. The company is expected to grow its bottom line by 2.0% per year on average beyond this year in the coming half decade.
The company has a history of increasing dividends, growing by 13.8% per year on average over the last decade and 11.0% per year on average over the last five years. The dividend is expected to grow in line with EPS, and the company has a 25-year consecutive history of paying dividends, indicating confidence in its continued payment.
Ethan Allen has had an average payout ratio of 48.2% over the past nine years, and with expected EPS growth, the company is likely to continue to have a low payout ratio in the intermediate term. The business has no debt, but it is vulnerable to economic downturns. Ethan Allen is not the cheapest retailer in its markets, but it has competitive advantages such as vertical integration, North American manufacturing operations, and made-to-order products.
With a 4.7% dividend yield, a forecasted 2% EPS CAGR, and an expected 9.2% annualized tailwind from valuation multiple expansion, ETD is poised to deliver exceptional 15.9% annualized total returns over the next half decade.
Print This: Poised for Strong Total Returns
Ennis, Inc. (EBF) is a printing and business documents company that has been able to maintain and generate shareholder value despite declining print volumes by offering additional services and add-ons. The company has also been actively acquiring other printing businesses over the past five years, with recent acquisitions including AmeriPrint and School Photo Marketing. With other players exiting the industry, Ennis is well-positioned to continue making beneficial acquisitions and further consolidate its competitive standing in the sector.
The company has had a volatile EPS track record due to challenging market conditions but has offset demand destruction through M&A. Ennis has returned capital to shareholders through a large dividend and has almost doubled its size over the past decade. The company's future earnings growth will depend largely on its ability to make future acquisitions.
Ennis has averaged a payout ratio of 70% over the past decade, and its current payout ratio of 61% should be supported by current earnings, but the company may find it challenging to maintain its dividend during a recession or sharp downturn in its industry. Ennis has a strong balance sheet, with $87 million in cash and no long-term debt, but management has indicated that it may use debt to fund an acquisition if the right deal arises.
With a 4.8% dividend yield, a forecasted 3% EPS CAGR, and an expected 3.1% annualized tailwind from valuation multiple expansion, EBF is poised to deliver strong 10.9% annualized total returns over the next half decade.
Final Thoughts
While small-cap stocks come with a bit of extra risk relative to large cap blue-chips, as our analysis of stocks such as MED, ETD, and EBF indicates, with greater risk comes greater reward potential. By prudently building a well-diversified portfolio of small-cap businesses, investors can generate outsized current income along with the potential to enjoy double-digit long-term annualized total returns without going out too far on the risk spectrum.
