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The small but mighty truth all income investors should know

The small but mighty truth all income investors should know

Standard Life Investments UK Smaller Companies Trust PLC Smaller companies are the ‘sweet spot’ of stock market investing on a total return basis, according to US financial services firm Cantor Fitzgerald.

“They are typically growth companies, but there are also enough around that pay dividends,” said Monica Tepes, research director at the investment bank. “There are a number of funds that themselves pay decent dividends; even some trusts that don’t have an income objective offer a decent yield.”

Standard Life UK Smaller Companies Trust is among them having grown its dividend year on year for the past decade. The companies in the Trust’s portfolio have tended to grow their earnings and dividends in the low teens over the longer term. Manager Harry Nimmo’s expectation, based on analyst forecasts, is that this will continue into the future, while he notes their income potential. “As a rule, dividend growth tends to follow earnings growth,” he said.

Whether seeking income or strong total returns, there are compelling reasons to look further down the market cap scale. 

1. Diversification

First and foremost, “income-seeking investors should consider the smaller companies asset class for diversification,” according to Ben Willis, head of research at UK Wealth manager Whitechurch Securities. Britain’s largest companies pay most of the dividends from the UK stock market. Royal Dutch Shell, for example, accounts for about £1 of every £7.50 of dividends paid.

The top five dividend payers in the FTSE All-Share provide 38% of the index income and the top 15 provide 58%. By contrast, the top five dividend payers in the Numis Smaller Companies Index pay just 9% and the top 15 pay 22%.

“In addition, the concentration of the income from the All-Share comes from a narrow band of sectors dominated by oil and gas, whereas you have far broader mix of companies and sectors providing dividends in the small cap arena,” said Willis.

2. Dividend growth

For Shore Financial Planning director Ben Yearsley, there is a very simple reason for going down the market cap scale when seeking income – faster income growth.

“To get growing dividends you need to be invested in companies that are actually growing the bottom and top line,” he said. “It’s far easier to grow a small company with turnover of say £10 million a year than a large cap with turnover of £10 billion.”

However, investors may have to sacrifice initial starting yield in return for the prospect of greater longer-term return potential.

“Whilst the big boys might offer a yield of 5% today (on a £10,000 investment that gives £500 a year, which if it doesn’t grow will still be the same in ten years), if you sacrifice that initial yield and, say, buy into a company with an initial yield of 3% (so £300 a year), but it can grow its dividend at 10% each year, by the sixth year you will have caught up and by year ten your dividend will be more than 50% higher and likely the share price will follow too,” said Yearsley, who advocates a “liberal sprinkling” of smaller companies in a balanced portfolio.

3. Dividend cover

Dividend cover (which shows whether or not net earnings will allow a company to maintain its dividend in the near future) has come under pressure among FTSE 100 companies.

“It was only the fall in the pound post-EU referendum that gave them room to breathe because most of their costs are in sterling but profits in dollars – so margins were better,” said Darius McDermott, managing director of Chelsea Financial Services.

“The fundamentals haven't changed though, so should sterling strengthen again, dividend cover would once again come into question; while the companies paying the largest dividends tend to be the bigger companies, there is more of a chance that they will either cut or stop their dividend payments completely.”

While dividends from the FTSE All-Share are only 1.3x covered by earnings, the Numis Smaller Companies Index boasts dividend cover of 2.8x.

Standard Life UK Smaller Companies Trust

Cantor Fitzgerald research director Monica Tepes highlights Standard Life UK Smaller Companies Trust as having “one of the best track records around.”

Its dividend has been covered by revenue earnings since 2009 and the Trust’s historical dividend yield currently stands at 1.6%.

Harry Nimmo has been at the helm of the Trust for almost 14 years. His investment approach is disciplined and, although the Trust can underperform rapidly rising markets, his focus on quality growth has generated significant outperformance over the long term.

“He is an excellent fund manager, who has consistently delivered strong long-term returns over ten years and more, outperforming both the sector average and the Numis Smaller Companies Index,’ said Ben Yearsley at Shore Financial.

Since 2007, the portfolio has been managed on a high-conviction basis and typically comprises around 60 holdings. The manager is willing to take significant active stock and sector positions.

As Ben Willis at Whitechurch Securities points out, Nimmo likes to stay invested in companies that reward his faith. “He will hold companies that initially were small caps and have moved up the cap scale due to being successful businesses,” he said. ‘Performance has been very strong under Nimmo and this is an excellent choice if looking to invest in a UK smaller companies trust.’

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The opinions expressed are those of © Standard Life Aberdeen as of July 2017 and are subject to change at any time due to changes in market or economic conditions.

This material is for informational purposes only. This should not be relied upon as a forecast, research or investment advice.

The value of an investment and any income from it can fall as well as rise and is not guaranteed. An investor may get back less than they put in. Past performance is not a guide to future performance.

Issued and approved by © Standard Life Aberdeen.© Standard Life Aberdeen is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. © Standard Life Aberdeen is authorised and regulated by the Financial Conduct Authority.

© Standard Life Aberdeen, images reproduced under licence.

This article was provided by Standard Life Investments and does not necessarily reflect the views of Citywire

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