2 small-cap stocks I'd buy with dividends yielding more than 4%

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House building site

Given the prospects for a rising inflation rate during the course of 2017, higher-yielding shares could become increasingly popular among investors. Certainly, large-cap shares in the FTSE 100 may be the obvious choice in many cases. However, there are also a number of smaller companies that yield 4% or more and that could offer strong capital gains over the medium term.

Improving performance

Monday's update from UK developer and constructor of multi-occupancy property assets, Watkin Jones (LSE: WJG), showed that it is making encouraging progress with its strategy. It performed in line with expectations during the first six months of the year, with five student accommodation developments sold in the first half of the year. They represented 2,347 beds in total, with a gross development value of £192m.

The company has a further six developments totalling over 1,705 beds under offer. It also has 11,098 targeted beds in its secured pipeline, with 9,390 of these having planning consent. Since the market for purpose-built student accommodation remains buoyant, Watkin Jones is expected to record a rise in its bottom line of 13% next year. Alongside a price-to-earnings (P/E) ratio of just 11.4, this indicates that upside potential may be high.

In terms of its dividend potential, Watkin Jones currently yields 4.1% from a dividend which is covered 2.1 times by profit. This indicates that its current payout is sustainable and could even grow at a faster pace than its bottom line. Given the likely rise in demand for strong, sustainable yields, the company could therefore become increasingly popular among investors over the medium term.

Upbeat outlook

The UK housing market continues to perform well despite uncertainty. Housebuilders such as Telford Homes (LSE: TEF) have bright growth prospects, with the company expected to record a rise in its earnings of 35% in the current year and 18% in the next financial year.

While there is scope for a downgrade to its outlook due to the potentially negative impact of Brexit, a wide margin of safety appears to be on offer. Telford Homes trades on a P/E ratio of only 10.1, which indicates there is upward re-rating potential. Certainly, higher inflation could mean demand for housing comes under pressure. The affordability of mortgages may fall if consumer disposable incomes are squeezed as wage growth dips below inflation. However, with a major imbalance between demand and supply, the long-term outlook for the industry appears to be positive.

Telford Homes currently yields 4.5% from a dividend which is covered three times by profit. This shows that even a decline in profit growth would be unlikely to cause a reduction in dividends. Therefore, the company could prove to be a far more resilient income stock than the market currently appears to be pricing-in. As such, now could be the perfect time to buy it for the long term.

The best dividend stocks?

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Peter Stephens owns shares of Watkin Jones. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.