Diversify to secure long-term growth

The US Federal Reserve’s inaction regarding interest rates has allowed some breathing space, although UK inflation has exceeded targets and forecasts have been revised, which has added to domestic economic uncertainty.

Investor sentiment in emerging markets has generally recovered, although whether this will continue following a US interest rate rise is yet to be seen. The global landscape is further complicated by Syria’s civil war, which has been exacerbated by terrorist group IS’s opportunistic invasion.

This less-than-perfect backdrop for markets has led to the increasing realisation that income strategies are appropriate both for wealth creation and income provision to support rising living costs. Income investors represent a growing segment of the UK population given the ascent of defined contribution pension plans in place of defined benefit schemes, and the number of people reaching retirement age increasing.

Small company investing is a specialist area and requires a greater deal of due diligence than may be required in the large-cap arena

This trend has been further reinforced by the pension freedoms act, which allows retirees to select alternatives to traditional annuities. However, generating a high and sustainable income stream within a low growth, low interest rate environment continues to be a quandary for investors.

Fixed income is no longer the obvious go-to place for quality income, and prime commercial property valuations appear increasingly overvalued. As a result many investors are turning to equity income for yield, for which the UK market can present a compelling opportunity.

This has led to significant inflows into UK equity income funds in recent years, resulting in a high concentration of investment in the same companies: research has shown that 23 per cent of all assets in the sector are invested in the same 10 stocks. 

One reason for this is that some of the larger funds are simply unable to take a meaningful position in quality firms further down the market-cap scale due to size. But diversification across the smaller- and mid-cap markets has considerable merit, and this is where managers and smaller funds are able to differentiate and provide investors with access to attractive returns.

A number of UK equity income funds have adopted a multi-cap approach and a skew towards small- and mid-cap companies. Smaller firms are an untapped income resource for a number of reasons, primarily due to the largest funds being unable to invest in this space. 

Nonetheless, there are numerous reasons why small caps can present an attractive alternative, or even a complementary holding, to large-cap equity income portfolios.

Smaller companies have generated greater returns than larger ones in the past 10 years and have done so with lower levels of volatility, thus providing investors access to attractive risk-adjusted returns. These businesses are often under-researched and operate in an inefficient market, presenting opportunities for diligent investors to capitalise on. 

They tend to be nimbler and more flexible than larger companies with faster growth potential. Board members’ interests tend to have greater alignment with their investors and many of these businesses are highly cash-generative, which allows them to pay attractive dividends that are able to grow over time.

Small company investing is a specialist area and requires a greater deal of due diligence than may be required in the large-cap arena. 

It is also important that managers distinguish between new and growing start-ups as opposed to the small companies that fulfil a niche and have free cashflow at their disposal to reward shareholders. 

Other advantages of smaller businesses lie in their ability to provide portfolio diversification and an ability to deliver better return outcomes, as well as helping smooth overall portfolio volatility. 

Ultimately, there seems to be a growing consensus that it is pragmatic to diversify income streams across the market-cap spectrum. Doing so within a high-conviction portfolio should provide investors with a strong opportunity for a premium yield and long-term capital growth.

James Lynch is an investment manager at Downing