It is a commonly known fact that many UK equity income strategies are disproportionately invested in a relatively small number of large-cap stocks. This is unsurprising, considering 55 per cent of FTSE 100 dividends are forecast to come from just 10 companies in 2018.
The herding towards mega-cap companies offering high yields has therefore created major levels of overlap and correlation within strategies in the Investment Association UK Equity Income sector. However, this does not need to be the case.
If investors are prepared to look beyond the well-known stocks, which are usually housed in the large-cap area of the market, there are numerous, smaller under-the-radar companies with potential to generate considerable dividend growth over the coming years.
This also offers the opportunity for much-needed diversification of the sources of income and hence low correlation to large-cap focused portfolios.
We believe it is the opportune time to be looking more closely at smaller companies within the UK market. This is primarily due to the political uncertainty that continues to hover over the UK. In our view, there are many smaller companies outperforming larger and more cyclical peers.
Niche positioning and agility
Small-cap stocks have the potential to navigate more smoothly through economic headwinds, due to niche positioning and agility.
This differs from large-cap businesses, which are more likely to be impacted by global macroeconomic factors.
- Investors looking for income should consider small caps
- There are many small companies well established in their fields
- Smaller companies are not so well researched by analysts
However, when seeking to unearth some of the most attractive income opportunities available at the smaller end of the UK market, it pays to be selective. Some managers specifically seek opportunities in the sectors driving the UK economy. These sectors would be the technology, media and telecoms; healthcare and education; consumer markets; and business services sectors.
These spaces, which we believe are vital for the UK’s future growth potential, currently account for about 75 per cent of the UK’s GDP.
By focusing on the sectors and businesses meeting fundamental criteria, it is possible to help screen out loss-making or earlier stage businesses and cyclical areas that are typically higher risk.
We believe this approach helps provide substantial mitigation to some of the inherent risks of investing in smaller companies.
The income misconception
When it comes to investing in smaller companies, some people may believe it is exclusively the domain of managers running so-called ‘growth’ strategies.
This is a major misconception. While small-cap stocks are obviously not as large as FTSE 100 constituents, it is still possible to unearth numerous well-established companies operating in niches or with strong positions in smaller mature markets.
In many cases, these companies are generating significant cash flows and do not need to invest too much capital for growth, due to capital-light business models or the maturity of their niche industry. These companies therefore have the potential ability to pay attractive dividends to shareholders.
There are also companies generating solid cash flows facing natural constraints on how rapidly they can invest in their own growth.