Why investing in large caps pays dividends

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.

Another major UK conglomerate, BP, notably suspended its dividend as part of its commitments to compensate victims of the Gulf oil spill in 2010. 

Jason Hollands, managing director at Tilney Bestinvest said: “Investors should be aware that even the larger blue chips can have set backs, and being invested in a large company does not guarantee the fruition of the targeted dividend level.

“Most UK equity income contains the same four or five companies that have a good track record of achieving their dividend target, but there is certainly a case for investors to diversify their portfolio for dividends to include funds that solely invest in small and mid caps.”

Star fund manager Neil Woodford expressed disappointment over the performance of his £9.2bn flagship fund, which lagged behind the FTSE All Share. The fund returned just 3.4 per cent last year compared to 16.8 per cent by the index over the same period.

The fund's top 10 holdings boast a number of FTSE 100 dividend champions, but beyond this there is a greater focus on less well-known firms and even the presence of unquoted companies.

Mr Woodford pointed to a rally in commodity stocks as one of the main factors behind the fund’s performance.

Jason Broomer, head of investment at Square Mile Investment Consulting and Research, said: "Neil tends to have large core positions in larger companies typically in the pharmaceutical space, and between 20 and 25 small cap stocks that may not be income generating. Last year was not a good year for pharmaceuticals and small caps did not do so well." 

While small and mid caps generated a good cash levels with better dividend cover, they are at risk in the wake of the Brexit vote, conversely, depreciation in the British currency can help large-cap exporters.

Mr McDermott said: “Small and mid caps tend to be more domestic focused, which is set to come under some pressure with Brexit and thus will hurt these companies. I believe if you do your research thoroughly, there is still opportunity to get income in small and mid-cap companies.

The Unicorn UK Income fund, for example, which has a concentrated portfolio focused on the small and mid-cap space, ranks third in FE Analytics list of top-performing funds in the IA UK Equity Income sector over a five-year period.

Mr Broomer said: "Small and mid caps have done well, especially over a five-year period, but 2016 was a particularly difficult year for these stocks. Large companies tend to have numerous areas of business, so are able to recover from macro shocks unlike smaller businesses that do not have as many layers."

There is an increasing trend of large companies using debt amid a low interest rate environment to prop up their dividend payments.

“The practice is certainly worth noting,” Mr McDermott said.

“Some managers would say they have concerns about debt funding dividends, but it is not sustainable over the medium term. However, it could be sustainable in the short term if cash flow generation is due to improve.”

Lee Gardhouse, chief investment officer at Hargreaves Lansdown, concurred. Mr Gardhouse said: “They definitely should be doing it as long as it is done in a sensible fashion. It makes sense to do so if the cost of capital is lower than the return.

“It can leverage up equity holdings as long as it is done in a sensible fashion. The reason why utility companies made investors so much money over a long period of time is down to borrowing money to leverage equity holder position.”

He added: “Small companies have less access the debt market, and where they do have access, they have to pay a higher fee. One of the most common ways that smaller companies raise capital is through a bank loan, but they tend to be short term.”

“Debt markets have been easily accessible to large companies,” Mr Gardhouse explained, adding that smaller companies have tended not to rely on debt markets to pay off dividends."

Myron Jobson is a features writer at Financial Adviser

Key points

The top 10 dividend payers have been stable since 2009, according to the Sanlam Private Wealth report.

The plight of Pearson is a timely reminder of the danger of investing solely in large caps.

Small and mid caps have been buffeted by the Brexit vote.