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.
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 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.
Key Points
- 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.
This may include the pace at which they can practically recruit and integrate skilled staff, or ensuring they build sometimes immature operational infrastructure in a measured way to cope with expansion.
Listed small-cap companies are often careful about taking on too much for fear of overheating, which would have serious repercussions on credibility. Most smaller companies are committed to maintaining sensible balance sheets and rewarding shareholders for being patient over the course of the journey.
After all, these are likely to be the same shareholders that could support them with more capital should a major attractive opportunity develop in the future.
There is also a perception held by many in the market, particularly among institutional investors, that companies paying a dividend, even if initially small, demonstrate good financial discipline and have moved into a more established phase of their development as listed businesses.
Under-the-radar opportunities
While large-cap stocks in the FTSE 100 are well covered by research analysts, those further down the scale are comparatively under-researched and offer income and growth for those who know where to look. For example, one stock unlikely to feature in many UK equity income portfolios is Strix. This company is the world leader in kettle controls, with a 38 per cent share of the global market.
Strix was admitted to the Alternative Investment Market in August last year at 100p per share; with its share price today up at about 165p it still offers a prospective yield above 4 per cent.
Another hidden gem is Vianet, the UK market leader in beer flow monitoring systems in pub groups. Operating in a niche industry, the company offers a near 5 cent yield underpinned by solid cash generation.
Leveraging the technology from beer flow monitoring, it also provides telemetry for vending machines. The company has delivered consistently strong dividends over many years and is a classic example of a mature smaller company operating in a niche space.
Finally, another stock where there are strong long-term prospects is Knights Group, a UK legal services business focused on providing commercial legal advice to businesses in regional UK towns and cities.
It has good quality earnings streams with diversification across customer, fee earner and area of legal service – as well as a high degree of repeat revenue from existing customers. Management has driven a strong growth strategy: combining recruitment of quality regional lawyers, as well as making acquisitions at attractive multiples.
Knights achieves high earnings before interest, tax, depreciation and amortisation margins for the sector, through driving market leading efficiencies in the ratio of fee earners to non-fee earners.
Operating in a large addressable market, it offers the prospects of long-term profit and cash flow growth to support an attractive and growing dividend stream.
Ken Wotton is manager of the LF Livingbridge UK Multi Cap Income Fund
