What Dividend Growth Investing Should Look Like

by JT McGee

Dividend growth investing is all about buying companies that have the potential to raise their dividends year after year. The idea is simple: buy into a company that has and will continue to raise its dividends over time, and draw a growing stream of income while enjoying capital gains on the side.

There’s only one drawback. Large stable companies tend to pay dividends. Thus, most dividend growth investors are stuck in the large cap universe, buying big, established companies that are household names. Well-known companies can also get a little pricey.

If you’ve been here for any amount of time, you know that the big companies aren’t my schtick. I like the small stuff no one else wants to touch. But I just ran into a dividend growth name in the small cap space, and I think I can tempt a few dividend investors to go deeper in the markets with this one.

My favorite small bank

Chesapeake Financial Shares (CPKF) is a very interesting, very small community bank that trades for an extreme discount to the broad market despite rewarding investors with 21 years of annual dividend increases and having one of the best investor websites on the planet.

So here’s the low down on Chesapeake. It’s a small bank holding company based in Virginia that claims two businesses: a basic banking operation (complete with a killer merchant card processing business growing at 20% YoY) and a wealth management firm. As of the recent quarterly report, Chesapeake had $643.5 million in assets.

The numbers look great. Net interest margin comes in at an incredible 4.6%, while nonperforming assets are rising, but still under 3% of total assets for 2012. But they’re not juicing returns and adding risk. Even in 2008 and 2009, during the midst of a financial crisis, this small community bank turned a profit. It helps that the bank has very significant non-interest income to keep it ticking when the cyclical business of lending falls through.

An impressive track record is a great indicator that the bank is well-managed and shareholder focused. The year 2012 was the fifth time in a row that Chesapeake was in the top 20 American community banks when measured by return on equity. (ROE topped 13% for the first quarter of 2013.)

Valuing Chesapeake

At $17.50 per share, Chesapeake earns a $57.1 million valuation, and thus trades at 7x earnings, and at a discount to book value of $61 million at year-end. Assuming no growth and the business simply stagnates, we’re at a 14% annual return to book value. 14%? That’s not just good, but great.

But there’s more. Add in the discount to book value and the fact that Chesapeake grew its bottom line by 10% in just the past year and you’ve found a winner. Ten percent earnings growth on top of a 14% earnings yield is incredible. (One would think 10% growth isn’t sustainable, but Chesapeake has managed 9% annual deposit growth through three different decades.)

If we slap together 10% and 14%, we can call it a 24% annual return. Dig it.

It takes work

But there’s the only problem: this company is horrendously illiquid. Some days will pass with not a single share trading hands.

The good news is that Chesapeake is a fan of share repurchases, so selling isn’t nearly as hard as buying. At an average pace of 350 shares per day, you could throw about $3,500 a day into the position if you buy half the volume. That’s not too bad. Small? Yes. But hey, people spend all day trying to find a P2P loan to sink $25 into.

And here’s where we get to the point of buying small and micro cap stocks: they’re freaking cheap. Rarely will you find a company that was profitable for every single year, grows bottom line income (and dividends!) at 10% per year, and sells for only 7 times earnings. The market just doesn’t let that happen.

This is a diamond in the rough; the kind of company that will never appear in a headline, never be the topic of discussion on CNBC, and never be a household name. But is the kind of company that you can buy very cheap because other investors fear that they won’t be able to own enough of it.

Disclosure: I own Chesapeake Financial Shares and plan to own it for a long time.

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