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Life in the microcosm

Foreign income portfolios may have been the fashion of the past year or so but smaller company income may be the latest fund trend for the coming year.

Much has been talked of the heavy concentration of FTSE 100 dividends into just a handful of companies. That has been the rationale used by groups introducing international portfolios. But some believe there remain strong and diverse UK income opportunities, just further down the market-cap scale.

There are only a few dedicated small-cap income funds and while some UK equity income funds are run on an all-cap basis, few managers go beyond marginal smaller- company exposure and fewer still explore the micro-cap arena.

For some, it is simply impossible. There are nine funds in the IMA’s UK equity income sector with more than £1bn in assets under management, the biggest sitting at just over £10 billion, Invesco Perpetual high income. Managers such as Neil Woodford may like smaller companies for income opportunities but it is hard for a multi-billion-pound fund to take a stake in companies with a market cap of £50m-£100m.

In fact, Woodford does have micro and small-cap positions but the size of his fund makes it tough to make these anything beyond marginal. Currently, his high -income fund has just 0.93 per cent in companies with a market size of £50m-£99m while those between £100m and £249m account for 2.07 per cent.

Mid-caps may be better represented in traditional UK equity income funds but it is the smallest end of the market – micro and fledgling stocks – where dedicated small-cap income managers see the greatest opportunity.

Already strong performance has rocketed such portfolios to the top of the very competitive IMA equity income sector over one year. Over the 12 months to April 14, Unicorn UK income is number one in the sector, bid to bid, with gains of more than 32 per cent, according to Financial Express data. It is followed by Chelverton UK equity income, which also has a small-cap bias.

Over the past year, assets in the Unicorn portfolio have also shot up, rising from just £2.5m a year ago to exceed £22m now – which is why its manager, John McClure, believes it is just a matter of time before groups start launching similar products.

McClure currently has just three per cent of his fund in FTSE 100 stocks, 30 per cent in FTSE small-cap companies, 23 per cent in the fledgling index and 12 per cent in Aim. The average market cap size in his portfolio is just £314m. This compares with Woodford’s fund, which has around 75 per cent in stocks greater than £10bn.

Gervais Williams, former small-cap manager at Gartmore, has recently added to the number of dedicated small-cap income funds with the launch of Diverse Income Trust via investment group, MAM. Like McClure, he has limited large company exposure, with just 10 per cent in the FTSE 100 and 25 per cent in the 250. The remaining 65 per cent of his portfolio is in small, micro or fledgling stocks.

According to MAM’s research, while dividend-payers in the large-cap FTSE 100 may be proportionally high, the actual number is low in comparison with small caps. Of the companies in the FTSE 100, 91 pay out to shareholders. However, in the FTSE 250 there are 185 and in the small-cap arena out of 268 firms, 200 are dividend-payers. Of the fledgling index’s 98 constituents, 54 are dividend-payers while the Aim market features 187 firms with a bent towards shareholder payments. Not only are these found across a wide spread of sectors but many of these are also on comparable yields with their large-cap counterparts. Williams says the FTSE 100 yields around 3 per cent while the FTSE fledgling index yields closer to 4 per cent. In fact, of his 100 holdings – all of which are distributing – the smallest yield is 3.4 per cent.

If the opportunities are so great, why aren’t other UK income managers more inclined towards the small end? The restrictive size of funds aside, Williams and McClure believe some managers are constrained by liquidity concerns but this is not daunting to either of them. Williams says he has a broad enough portfolio that if he needed to sell a portion of each holding to meet investor demands, he is confident he could do so – even in adverse market conditions.

Williams also thinks liquidity concerns are overdone, preventing investors from accessing what he sees as the best-performing market. “In the past, smaller companies made up around 8 per cent of people’s portfolios, today they probably do not even have 4 per cent and, if I am right that this will be the best-performing area of the market, then they will be missing out.”

Liquidity, as Williams pointed out, can work both ways. Investors may be overly concerned about selling shares but illiquidity can also prevent their purchase.
It is not the situation of dividend concentration in the FTSE 100 that has led McClure and Williams to construct portfolios away from bigger companies. Instead, it is this belief in the opportunities they offer in the current climate.

According to McClure, we have only just seen the first part of the recovery process, with increased corporate yet to come and smaller companies are well positioned to benefit from that move.

Small-cap managers may spy that as an opportunity but it may be seen as another deterrent for existing equity income funds from accessing this end of the market. Lack of research on smaller companies means many are overlooked, providing investment value but to realise that value, knowledge and expertise in analysing smaller companies is vital, which is something that not all equity income managers, who have been more large-cap-focused, possess.

Smaller companies are well regarded as a capital growth play while income strategies have been pigeonholed as predominantly large-cap value. But just as investors have started to realise the UK is not the only yielding market, it is just a matter of time before those stereotypes fall by the wayside – especially if smaller companies continue to rise.

Small-cap income may be the next big fund launch trend – tapping into both strong capital growth and the income most fund groups claim everyone is seeking.


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