The UK Smaller Companies sector can yield more than the market as a whole
Investors and their advisers often harbour unchallenged assumptions about certain types of investment. Certain sectors, such as utilities, are seen as ‘income’ sectors. Others, such as technology, are classed as ‘growth’ sectors.
The same is often true of company size: large companies are assumed to be better for income seekers, while smaller companies are more suitable for the growth investor.
These generalisations are not entirely misplaced. Many smaller companies are at a relatively early stage of their development, where it is more important to plough any profits back into the business rather than paying them out to shareholders.
Smaller businesses on a faster growth trajectory will tend to require the internally generated cash more than larger, more mature companies, which have less of a growth dynamic, and the more limited availability of bank finance for smaller companies can make them more cautious on paying cash back to shareholders.
There may be other reasons why smaller company managements choose not to focus on dividends, for example their shareholder base may have tax circumstances that lead them not to want to receive dividends in the short term.
However, this is far from exclusively the case, and there are in fact some attractive dividends on offer from the smaller company sector.
From time to time – particularly when capital values are depressed, as was the case in 2008 – UK smaller companies, as measured by the Hoare Govett UK Smaller Companies Index, have yielded more than the market as a whole. This yield gap reversed in 2009 as smaller companies stormed ahead of their larger counterparts in capital growth terms.
The Hoare Govett UK Smaller Companies Index as a whole ended 2009 with a total return 24.1 percentage points ahead of the All Share, while the very smallest companies (as measured by the HG1000 XIC Index) did even better in total return terms, beating the All Share by 45.7 percentage points.
This divergence in performance, which has continued albeit more modestly in 2010 to date, has affected the relative yield of small versus large caps, but at this point in time, there is actually less than a 1% difference between the forward yield on the All Share and the Hoare Govett index, while the more restricted FTSE Small Cap index actually has a higher yield than the All Share.
Lost decades
It is always important to focus on the total return potential from investments rather than narrowly focusing on near-term income, and this applies equally to large and small companies. UK large caps suffered a ‘lost decade’ in the noughties with the FTSE 100 ending up more than 1,500 points lower on 31 December 2009 than it had been a decade earlier.
But with dividends reinvested, a negative capital return of 21.9% is transformed into a positive 9% total return, while for smaller companies – again taking the Hoare Govett UK Smaller Companies index as the proxy – the numbers were up 15.4% and up 54.4% respectively.
Risky strategies
Investing in any stock purely for income is a risky strategy, and many companies across the size spectrum cut their dividend payouts as profits came under pressure during the recession. Any company can face a sudden change in its financial position, which requires it to reassess the payment it can deliver to equity investors.
The current problems of BP with the oil leak in the Gulf of Mexico, forcing the company to suspend dividend payments, illustrate no company however large can be 100% sure to deliver on the dividend front. The importance of BP’s payment in relation to the overall level of dividend payments within the UK market has been brought home to many British investors in recent months, as pension funds, index trackers and UK equity funds in general have had their dividend income hammered by the suspension of dividends.
The beleaguered oil major was one of a handful of companies that accounted for the majority of the yield on the FTSE 100 Index, and the loss of the expected dividends has been felt keenly.
Global influences
A diversified portfolio of smaller companies arguably provides less dividend concentration than a portfolio of supposedly ‘safer’ blue chips. The diversification of income stream can be further enhanced by looking at smaller companies outside the UK more exposed to global rather than domestic influences.
Internationally, in the US, high dividend payments remain the exception rather than the rule across the stock market size spectrum, with share buybacks the more usual way in which companies ‘return’ capital. Elsewhere in the world, in Asia in particular, dividends are becoming more popular, and many companies here offer the attractive combination of good yields and exciting growth potential.
In Europe also, a growing number of companies are embracing the need to pay better dividends to shareholders as a way to make their shares more attractive. Of course, from a UK investor’s point of view, overseas companies’ dividend payments are subject to currency risk, but the long-term weakening trend of sterling tends to make this a positive rather than a negative.
Investing in smaller companies should never be done purely on income grounds, but over time a well-chosen portfolio of small and growing companies can hopefully deliver a premium in terms of both income and capital growth versus large caps, even if from time to time both capital and income could come under pressure.
Unlike open-ended funds, which must pay out the dividend income they receive in the year they get it, investment trusts are able to hold back in reserve some of the income they generate in a particular period, so dividends to shareholders potentially can be maintained or even increased in future periods even when the income stream coming into the portfolio has fallen. Judicious use of the revenue reserve has enabled trusts to maintain a trend of rising dividends to shareholders over many years, though of course such rises are not set in stone.
Peter Ewins, manager, F&C Global Smaller Companies
