Small Caps  

Why small caps can bring balance

Why small caps can bring balance

More than a decade after the financial crisis, interest rates remain at rock-bottom levels, with little prospect of a return to historic norms any time soon.

That has prompted some income seekers to move out of cash into risk-bearing assets – both fixed-income securities and equities – exposing them to the possibility of capital loss.

The trade-off for those seeking greater yield, in other words, is the prospect of volatility.

Managing that volatility is a key question for investors. But while the benefits of diversification are widely understood – the importance of not putting all your eggs in one basket – we see many income seekers end up with remarkably narrow portfolios.

For instance, equity-based income-oriented funds are often disproportionately weighted towards a relatively small number of large-cap blue-chip stocks. 

This year, just 10 FTSE 100 index stocks will generate more than half of all dividend payments, according to the stockbroker AJ Bell’s quarterly Dividend Dashboard.

This lack of diversity is problematic at the best of times, but looks especially worrying in the current environment.

Sustainability concerns

AJ Bell’s most recent report warns of serious question marks over whether the highest-yielding of these stocks can sustain their payouts at current levels.

Across the FTSE 100 as a whole, on the basis of 2018 forecasts, dividend cover – the extent to which its post-tax profits cover the cost of payouts – is currently running at a multiple of 1.71, which does not leave much margin for error.

Among the top 10 yielders, moreover, dividend cover now averages just 1.42.

Those numbers are concerning. Cuts in dividends expose investors to double jeopardy: not only does their income suffer, but a reduction in the payout is also likely to have a negative share price impact.

Key points

  • In a low interest rate environment income seekers have moved into more risk-bearing assets
  • Dividend cover is running at a multiple of 1.71, which is quite low
  • Some small-cap stocks can reduce portfolio volatility

The capital value of the portfolio takes a hit as well as the yield it generates.

This is not to argue that income seekers should now abandon the large FTSE 100 companies on which they have come to depend.

But right now, we believe it is more important than ever to broaden the universe of stocks generating yield. If the blue chips falter, investors would need to find compensation from other parts of their portfolio.

Small is not always risky

Enter small and micro-cap stocks. The traditional view of stock market investment is that the smaller the company, the greater the potential for volatility.

Small caps – and micro caps to an even greater extent – are meant to suffer more ups and downs over the course of the stock market cycle, raising the risk profile of investors with exposure to them.

The problem with conventional wisdom is thatit is a sweeping generalisation. It is certainly true that some small and micro caps are prone to elevated levels of volatility, but that does not mean every stock in thispart of the market fits the same mould.

In our view there are many good quality micro and small-cap listed companies with a robust strategy and business platform, good financial performance, and the right people in place to ensure the business is well placed for sustained growth.