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Why investing in large caps pays dividends

This article is part of
Quest for the Holy Grail

Why investing in large caps pays dividends

It would appear that size does matter when it comes to investing for income.

According to an equity income report by Sanlam Private Wealth, the largest 10 dividend payers represent around 30 per cent of the FTSE All-Share in terms of market capitalisation, but pay between 40 and 45 per cent of all UK market dividends.

The report said that while this ‘top 10’ has been stable since 2009, there is now a larger number of equity income funds above £2bn in size, and they appear to have greater exposure to some or all of the biggest names. The FTSE 100 companies producing high levels of dividends include HSBC Holdings, Royal Dutch Shell and BP.

FE Analytics data shows that over a three-year investment horizon three out of the top five best-performing dividend funds in the Investment Association UK Equity Sector have at least two of these three stocks in their respective top 10 holdings.

A skew to large caps over small and mid caps in recent history really did pay dividends. At the time of writing, the FTSE 100 dividend yield stood at around 3.71 per cent, while the figure for the FTSE 250 was 2.63 per cent.

The value of dividends paid by firms in the FTSE 100 is set to increase to £78.4bn this year – £4.6bn higher than 2016 forecasts, according to AJ Bell’s latest Dividend Dashboard report. However, the report also indicates that some top UK companies might struggle to maintain their payouts to shareholders during a bad year.

It found that dividend cover, which companies use to calculate whether they can afford to use their profits to pay shareholders, stood at a lowly figure of 1.46 times earnings. To put this into context, the ideal cover should be two times earnings because it means only half of a company's profits are being used to pay shareholders.

Darius McDermott, managing director of Chelsea Financial Services, said: “Dividends for larger companies have become tighter. It is debatable as to whether dividend paying companies are very well covered. There is only so many times a company can cut capex to meet dividend targets.”

Mr MacDermott added: “Cash generation has deteriorated for large caps. Large UK companies that export have been able to take advantage of a fall in sterling post Brexit, but we are unlikely to see another 20 per cent fall in sterling against the dollar again in the near future.”

The Sanlam report also revealed that several FTSE 100 index constituents, including energy companies, have been under pressure given the volatility in oil prices in 2016.

“Although there have been consistent dividend payments from these companies as they have been generating cash, returns to shareholders have clearly changed, driven by slower growth in China and changes in supply and demand dynamics,” it added.

The plight of Pearson is a timely reminder of the dangers of investors hedging their bets solely on larger companies for dividends. The FTSE 100 firm – former owner of Financial Adviser – recently issued its fifth profit warning in four years and signalled a cut in dividend from 2017 and scrapped its guidance to investors for 2018 profits.