Photo by Yiorgos Ntrahas on Unsplash
 

Most income-oriented investors focus on large-cap stocks, which are in principle more established and less risky than small-cap stocks. However, it is a shame to dismiss all the small-cap stocks and thus miss the exceptional return potential of some stocks of this category. In this article, we will discuss the prospects of three small-cap stocks which are attractively valued right now and hence are likely to offer great total returns to their shareholders in the upcoming years.
 

Enterprise Bancorp (EBTC)

Enterprise Bancorp has 27 full-service branches in the North Central region of Massachusetts and Southern New Hampshire. Thanks to its conservative strategy and its exemplary management, it is one of the highest-quality banks in the investing universe.

Enterprise has repeatedly proved its resilience to recessions. In the Great Recession, while most banks incurred excessive losses, Enterprise grew its earnings per share by 37%. In addition, its shareholders did not feel the impact of the fierce bear market, as the stock dipped only 3% whereas the S&P 500 plunged 55%. The bank has proved resilient to the coronavirus crisis as well. It posted a benign 9% decrease in its earnings per share in 2020 and has recovered swiftly, with record earnings per share in 2021 and nearly all-time high earnings per share in 2022. The defensive business model of Enterprise is especially important in the current investing environment, as the risk of an imminent recession has greatly increased due to the aggressive interest rate hikes implemented by the Fed.

It is also important to note that Enterprise has an exceptionally consistent performance record. To be sure, the bank has remained profitable for 132 consecutive quarters. This is a testament to its prudent management and its focus on sustainable long-term growth. The company has grown its earnings per share at an 11.8% average annual rate in the last decade and has grown its earnings per share in all but two years throughout this period. A consistent growth record is paramount when evaluating a stock.

Moreover, Enterprise enjoys positive business momentum right now, primarily thanks to the interest rate hikes of the Fed. Rising interest rates provide a strong tailwind to most banks, including Enterprise, as they enhance the net interest margin of banks to a great extent.

The merits of higher interest rates were clearly reflected in the latest earnings report of Enterprise. The company grew its loans and its deposits by 15% and 5%, respectively, over the prior year’s quarter. It also enhanced its net interest margin from 3.39% to 3.61% and thus it grew its net interest income by 11% and its earnings per share by 21%, from $0.81 to $0.98.

Thanks to its strong business outlook, Enterprise has raised its dividend by 11% this year. It has thus raised its dividend for 28 consecutive years and hence it is a Dividend Aristocrat. Given its solid payout ratio of 24% and its defensive business model, the company can easily continue raising its dividend for many more years. Therefore, while its 2.7% dividend yield is lackluster on the surface, the stock is suitable for income-oriented investors.

Notably, the stock is currently trading at a nearly 10-year low price-to-earnings ratio of 9.0, which is much lower than the 10-year average of 14.1 of the stock. The cheap valuation has resulted primarily from the impact of inflation on the valuation of the broad stock market, as inflation reduces the present value of future earnings. As soon as inflation begins to subside, the valuation of Enterprise will probably revert towards its historical average. Overall, Enterprise is likely to offer attractive returns to patient investors thanks to its reliable growth trajectory, its growing dividend, and its cheap valuation.
 

Tennant Company (TNC)

Tennant Company is a machinery company that produces cleaning products and offers cleaning solutions to its customers. It is the market leader in the U.S., but it also sells its products in more than 100 countries around the globe.

Thanks to its dominant position in its business, Tennant enjoys some significant competitive advantages. It has greater pricing power than its smaller competitors while it also benefits from great economics of scale, which reduces its cost basis and thus makes it hard for small peers to compete with Tennant.

Tennant has raised its dividend for 50 consecutive years and hence it is a Dividend King. However, it has proved less resilient to recessions than most Dividend Kings. For instance, during the Great Recession, the company incurred a 52% decrease in its earnings per share. It also proved vulnerable to the coronavirus crisis, as it posted a 23% decrease in its earnings per share in 2020.

Moreover, Tennant has exhibited a more volatile performance record than most Dividend Kings. During the last decade, the company has more than doubled its earnings per share but with much less consistency than other Dividend Kings. Nevertheless, Tennant has promising growth potential ahead.

Tennant pursues growth primarily via acquisitions, especially in the Asia/Pacific region, where it benefits from above-average market growth rates. The acquisition of Chinese cleaning equipment company Gaomei is a promising growth driver for Tennant in the Chinese market, as well as in other Asian markets. In addition, Tennant has recovered strongly from the pandemic. It posted all-time high earnings per share of $4.39 in 2021 and has provided guidance for earnings per share of $4.15-$4.75 this year, implying new all-time high earnings per share at the mid-point.

Tennant is a Dividend King but it is currently offering a dividend yield of only 1.8%. The company has a payout ratio of only 23% and hence there is ample room for meaningful dividend hikes. However, management has proved that it prefers to raise its dividend at a slow pace in order to maintain a rock-solid balance sheet and thus have funds available for acquisitions. Tennant has grown its dividend by only 3.9% per year over the last decade and 3.6% per year over the last five years. This means that income investors should not purchase this stock for its dividend, but for its promising growth prospects.
 

Industrial Logistics Properties Trust (ILPT)

Industrial Logistics Properties Trust is a REIT that owns and leases industrial and logistics properties throughout the U.S. After the acquisition of Monmouth Real Estate Investment, the trust has 412 properties. It has 226 properties on the island of Oahu, Hawaii, and 186 properties in 38 other states on the mainland. Therefore, Industrial Logistics Properties Trust generates 29% of its rent revenues from the state of Hawaii.

In the third quarter, Industrial Logistics Properties Trust cut its quarterly dividend by 97%, from $0.33 to $0.01, in order to enhance its liquidity, which suffered due to the acquisition of Monmouth. The company initially anticipated that its dividend would return to a rate close to its previous rate next year. However, management recently hinted that it will take longer for the dividend to be restored.

The impact of the acquisition on the performance of Industrial Logistics Properties Trust was evident in its latest earnings report. Rental income jumped 88% over the prior-year period thanks to the acquisition of Monmouth but funds from operations (FFO) per unit slumped 50% due to a steep increase in interest expense as well as operating costs. The stock has plunged 81% this year due to the high debt load that has resulted from the takeover of Monmouth and the drastic dividend cut.

On the bright side, the stock has been sold off to the extreme. It is now trading at a price-to-FFO ratio of 3.3, which is extremely low. As soon as the REIT reduces its debt to a more reasonable level, its valuation will probably revert toward normal price-to-FFO levels. Therefore, the REIT has the potential to offer high returns to patient investors, who can ignore short-term pressure and remain focused in the long run.
 

Final Thoughts

The above three small-cap stocks have the potential to highly reward investors in the upcoming years, partly thanks to their attractive valuation levels right now. Among the three stocks, Enterprise is by far the least risky and most reliable stock whereas Industrial Logistics Properties Trust can offer excessive returns but it will be much more vulnerable than the other two stocks in the unlikely scenario of a prolonged recession.

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