Home to boost

The current extraordinarily low level of interest rates has benefited the borrowers in our society, most notably mortgage holders. However, there is a separate and larger constituency – namely savers – who have found the income stream produced by their savings reduced to almost nothing. The situation does not appear likely to improve in the near future. The Monetary Policy Committee is determined the UK avoids a Japanese-style bout of deflation and has made it clear it will use both conventional tools such as low interest rates and unconventional tools such as quantitative easing to do so. Even if the base rate was to rise, the banks’ balance sheets remain in such a parlous state the benefit is unlikely to find its way to the depositor.

For decades, UK equity income funds investing in blue-chip companies have generated an income stream for investors. However, the global financial crisis has made investors increasingly aware of the risks of having a concentrated source of income.

Dividend cuts

According to Capita, UK companies aggregate dividend payments fell by £10bn to £56.9bn (equivalent to a 15% cut) in 2009. Among the main sector groupings, only healthcare, utilities, and oil & gas companies raised their dividends, adding £4.2bn to their 2008 total. Every other sector cut, with financials alone distributing £8bn less than the previous year, with the banks responsible for the lion’s share of their sector’s decline.

As investors experienced last year with the banks, a single event can wipe out a whole sector’s income stream. Similarly, a downward shift in the oil price, or the effect of patented drugs coming off patent, could seriously damage the revenue streams of the entire oil & gas or pharmaceutical sectors. While these events may seem unlikely, the events of last year have understandably led to investors looking to diversify their sources of income.

Home opportunities

Overseas markets appear to be top of investors’ destinations. To meet this demand, many fund management groups have launched global or regional equity income vehicles. However, while companies in Asia, Europe and Latin America can offer attractive dividend yields, investors should not overlook opportunities closer to home.

Indeed, in contrast to their blue-chip peers, UK smaller companies have a much smoother revenue profile across sectors, with the exception of the support services sector. This is the catch-all for companies that do not fit elsewhere, is a very heterogeneous sector, and consequently, while dividend cuts are very possible, a single event is unlikely to wipe out the whole sector’s revenue stream.

Furthermore, the small-cap universe is less reliant on individual companies’ dividend contributions. The graph below illustrates the top 15 dividend payers in the FTSE 100 contribute nearly 70% of the index’s dividends. Whereas in terms of the FTSE Small Cap index, it is just 32%.

Interestingly, it is possible to construct an income portfolio of small companies without being overly reliant on the top 15 income contributors. Companies I currently favour outside the top 15 offering an attractive yield and, importantly, dividend growth include The Restaurant Group, Mothercare and XP Power.

Resilience

The Restaurant Group has successfully demonstrated the resilience of its business model throughout the recession. Management has used internally generated cashflows to grow the business. Importantly, they are very focused on the returns they generate from these investments. The cash-generative nature of the business has allowed them to pay an above-average yield while delivering this growth. At their most recent results, they reported 5% growth in earnings, a reduction in net debt, an acceleration in their growth targets and a 4% increase in the dividend.

Mothercare has continued to successfully develop its business and the growth from its overseas operations has been particularly pleasing. This, combined with a strong balance sheet, has allowed Mothercare to increase its dividend by almost 20% at its last results. XP Power has spent the last few years investing in their product pipeline while also improving the underlying quality of the existing business. This has meant margins have expanded significantly and growth in new product sales is about to accelerate. Despite the changes taking place throughout the company, the management team have retained their focus on generating shareholder returns. Although they have been impacted by the effects of the recession, they still managed to report record earnings per share and a near 5% increase in the dividend at their latest results announcement.

Complimentary

However, it is important to stress small caps should not be seen as an alternative to obtaining income from UK blue chips or an overseas portfolio of companies. Instead, investors should view an allocation to small caps as complementing their other sources of income.

Dividends are clearly a crucial component of total return for shareholders. But they are also a sign of management discipline and their commitment to generating a tangible return for their investors. Management teams are increasingly recognising this; after all, the more supportive their investors are, the lower their cost of capital.

Over the medium term, small companies are expected to grow their profitability more rapidly than their larger counterparts and, given managements’ focus on the dividend, I would expect this to be reflected in growth in the dividends as well.

There is a great deal of uncertainty surrounding the outlook for the UK economy and its consequent impact on company profitability. However, as the examples above demonstrate, it is still possible to find good-quality companies at attractive valuations with above-average yields.

Ed Beal is manager of Dunedin Smaller Companies Investment Trust

Index income contribution:

Categories: Equities

Tags: Uk | Capita | Smaller companies | Ftse 100

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