Why small can be beautiful for income fund investors

Funds investing in dividend-paying large companies have fared well of late, but with cheaper valuations and less of a concentration problem there’s a strong case for considering UK equity funds that look for income among smaller companies.

While the reassurance of a regular dividend is welcome, equity income strategies have their flaws. Too often, they can steer investors to a handful of solid, but dull companies, concentrated in a limited range of sectors.

While these companies have done well over the past 12 months, investors are often sacrificing capital growth. Smaller companies could present a solution, particularly given this part of the market is out of favour, reflected by its lower valuations.

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Traditional equity income strategies have a concentration problem. The latest Link UK Dividend Monitor shows five stocks making up 28% of all dividend payments in the UK – Rio Tinto (LSE:RIO), Shell (LSE:SHEL), British American Tobacco (LSE:BATS), HSBC (LSE:HSBA) and Glencore (LSE:GLEN). Around one-third of dividends come from commodity-related sectors, such as mining and energy, with a similar amount coming from the banking sector. These sectors have their moments in the sun, but are sensitive to the economic cycle.

Dividend concentration an issue for UK income seekers

Gavin Haynes, investment consultant at Fairview Investing, says: “Dividend concentration is an issue in the UK with the largest 10 dividend payers accounting for over 50% of dividends generated by the market. As a result, many the mainstream UK equity incomefunds have a high degree of commonality.”

It means that dividend investments tend to perform well only at certain points in the market cycle and an investor’s income stream is vulnerable to problems in specific sectors.

This is not just true for the UK market. While there is greater diversity in emerging economies or across Asia, large-cap dividend stocks show similar concentration the world over. The S&P Dividend Aristocrats, for example, is almost 50% weighted to consumer staples and industrials. Equally, some key sectors are very poorly represented across the world – notably technology. This helps explain the relative weakness of equity income strategies over the past decade.

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In examining their options to turbocharge their income portfolios, smaller companies may not immediately spring to mind. Jack Moeller, senior investment consultant at Square Mile Investment Consulting, points out that as recently as 20 years ago, only around 20% of smaller companies paid a dividend. The theory went that fast-growing smaller companies should be reinvesting in their business, and dividends were a secondary consideration.

That view has shifted and today, around 50% of all smaller companies pay a dividend. Moeller says they are coming across smaller companies paying dividends at an earlier and earlier stage in their lifecycle, recognising that it signals good capital discipline, and widens their potential shareholder base.  

High dividend yields among small-cap stocks

Laurence Hulse, investment director at Dowgate Wealth points out there are currently at least 33 companies with a market cap of less than £1.5 billion market cap that pay a dividend yield of 5% or higher, versus 20 above that threshold.

A recent report from Octopus Investment forecast that the yield on the FTSE Small Cap index is predicted to be 3.8% for 2023, almost in line with 3.9% forecasted yield for the FTSE 100. For global small-caps, the rate is slightly lower – the MSCI Global Small Cap has a dividend yield of 2.3%, but this is still marginally higher than the yield available on the large-cap focused MSCI All World index.

Fraser Mackersie, fund manager at Unicorn Asset Management, says that higher yielding UK small and mid-caps now provide a real option for investors looking to diversify their income stream.

He says: “There are a large number of high-quality, high yielding companies further down the market capitalisation range with excellent long-term dividend track records. Attractive dividend yields are complemented by the prospect for meaningful growth in profits.

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He believes an income approach can also guide investors to better quality small-caps. Mackersie points out: “The ability of companies to fund future growth opportunities and make dividend payments to shareholders demonstrates a strong capital discipline and is an attractive combination for income-seeking investors.”

Opportunity to diversify and potential outperformance

Small-caps also bring a greater breadth of sectors. Haynes says: “Investing in smaller companies can provide a good way to diversify equity income exposure away from the heavyweight oil, miners, pharmaceuticals, tobacco and banks that dominate the UK equity income sector. UK smaller companies can offer dividend streams that are much more diversified on both a sector and stock level with attractive yields on offer.”

However, perhaps the real selling point for smaller company dividends is their stronger growth prospects in both dividends and capital. Small-caps have historically grown faster than large-caps.

Alex Watts, data analyst at interactive investor, says: “Over the longer term, small-caps have proved their ability to outperform, albeit with greater volatility. The UK Smaller Companies Investment Association sector returned an annualised 8% over 10 years, in spite of recent drawdowns, versus 6% for the UK All Companies sector.

“A similar story of smaller company long-term outperformance is true of European and Japanese fund sectors over 10 years.”

The exception is the US, largely because of the influence of large-cap technology stocks.

Smaller company strategies among ‘dividend heroes’

Across most of the world, and for most of the time, smaller companies are growing faster, allowing them to deliver stronger dividend growth. There are now smaller companies funds appearing as the ‘next generation’ of AIC dividend heroes list (which highlights those investment trusts that have grown their payouts to shareholders year after year) – BlackRock Smaller Companies (LSE:BRSC), Henderson Smaller Companies (LSE:HSL), Chelverton UK Dividend Trust (LSE:SDV), Aberforth Smaller Companies (LSE:ASL) - have all grown their payouts to investors for a decade or more.

The BlackRock trust has a five-year annualised dividend growth rate of more than 10%. The Global Smaller Companies Trust (LSE:GSCT), managed by Columbia Threadneedle, is a full-blown ‘dividend hero’ having grown its dividend for more than 50 years in a row.

Investors may understandably be deterred by the recent performance of the small-cap sector. 2022 was a dismal year for the sector, with the average UK smaller companies fund falling over 25%, and the average European smaller companies fund dropping 21%. Sentiment towards global smaller companies has yet to revive, while the global economic outlook remains precarious.

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There are still vulnerabilities for the global economy, but Haynes points out that small-cap valuations have fallen a long way: “Although they may remain out of favour if the economic outlook worsens, a lot of bad news is priced in and depressed valuations can provide contrarian opportunities for good stock-pickers.”

Watts says: “It is possible that market participants have been overzealous in their downward rating of small companies, and that current valuations of quality, cash-generative smaller companies offer long-term investors good upside potential, if able to weather short-term volatility along the way.”

History suggests that small-caps tend to do well at times of economic recovery and when they bounce, they move quickly. After a slump in 2007, small-caps rebounded significantly from 2008 to 2013. After a wobble in 2014, they bounced higher to 2017. Two more wobbles in 2018 and 2020 were both followed by significant, rapid recoveries.  

UK smaller company income fund ideas to play a recovery

For investors who are tempted, Haynes suggests Montanaro Income. He says: “The fund is focused on UK small-cap stocks and follows a 'quality growth' investment philosophy where they aim to buy best of breed companies and hold for the long-term. This fund will follow a sustainable approach meaning it avoid certain areas such as oil stocks, looking for companies that treat all stakeholders well, with solid governance.”

Those looking for a global option could consider the LF Montanaro Better World fund, which has a low starting yield, but attractive dividend growth. The Global Smaller Companies trust offers a similar profile, with a lower starting yield, but appealing growth in that income over time.

Dzmitry Lipski, interactive investor’s head of funds research, picks the Unicorn UK Ethical Income Fund.

He says: “The portfolio is concentrated with just over 30 holdings and is skewed to small and mid-cap stocks. It is managed by highly experienced managers Fraser Mackersie and Simon Moon, who have co-managed the fund since its launch in April 2016. The managers look for companies with good long-term growth prospects, that generate strong cash flows and offer an attractive dividend yield, while also meeting strict ethical criteria.

“It is one of very few UK funds to offer an ethical income yield and follows the same investment process as the better-known Unicorn UK Income fund. The fund offers an attractive yield of almost 5%.”

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He also likes Diverse Income Trust (LSE:DIVI), which can invest in UK companies of any size but has a bias towards medium-sized and small companies.

“Fund managers Gervais Williams and Martin Turner run a diversified portfolio of around 130 holdings. AIM and FTSE Small Cap account for more than 50% of the portfolio. The managers believe cash-generative stocks should outperform growth-oriented stocks during the rising interest rates and high inflation.” The trust currently yields 4.5% and is trading at a 5% discount.

Small-caps always come with greater risk, but they have fallen a long way and look good value today. Targeting companies paying a dividend can also be a way to steer a portfolio to higher-quality small caps. In the longer term, they can help bring some sparkle to an otherwise dull equity income portfolio.