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10 MINUTES WITH…DAVID TAYLOR

Several groups called for greater focus on overseas dividends after recent events at BP but Chelverton believes looking down the market-cap scale can produce similar results.

The group’s UK equity income fund is the best performer in the sector over the last year, bypassing the FTSE 100 and picking stocks from the sub-£1bn bottom 10 per cent of the market.

Manager David Taylor says this approach came out of Chelverton’s small and mid-cap expertise, with the firm set up by ex-3i manager David Horner in 1998.

They launched the open-ended vehicle at the end of 2006, with Taylor joining from HSBC earlier that year, looking to offer a solid yield product investing outside the traditional mega-caps.

Taylor’s basic approach is to filter out any stocks not yielding at least 50 per cent more than the small-cap benchmark, currently setting a floor of 3.8 per cent.

Marking the fund out from most of its peers, the Chelverton universe largely excludes small oils and miners for their lack of yield as well as banks and pharmaceuticals, with few smaller players in either sector. Taylor believes this approach means the portfolio offers considerable diversification benefits, both in its own right and relative to the benchmark, with 20 sectors represented.

Investing at the small end of the market does mean a definite maximum capacity for the fund but Taylor estim-ates a £200m ceiling and has plenty of room for growth from the current £20m under management.

He says: “Overall, our favoured stocks tend to be seen as dull but worthy so are generally undervalued.

“Our main competition for these companies would be other small-cap funds but most tend to focus on more growth-type opportunities so our stocks remain cheap.”

Academic evidence suggests small-cap value outperforms small-cap growth over the long term, according to Chelverton. The group believes the market cycle is now on the turn and smaller and mid-cap companies are best placed to respond, with current valuation levels providing substantial scope for further capital appreciation.

Chelverton UK equity income has a yield of just under 6 per cent from a combination of highand lower-income stocks and has grown its dividend in excess of inflation.

Taylor says the portfolio’s biggest sector exposure is in support services which is seen as something of a dumping ground for stocks that do not fit easily elsewhere, with decent positions in insurance companies as well as engin-eering firms. Taylor holds three basic types of company, with a solid 60-65 per cent core of steady performers that can grow their dividend above inflation. He tends to run these positions unless the share price rises too far and the yield therefore declines. His second strata of companies is those that suffer a profits warning but manage to maintain their dividend, dropping back into Chelverton’s universe, including stocks such as engineer Keller and household goods manufacturer McBride.

Finally, Taylor’s third area of opportunities is cheap companies likely to keep paying their dividend but unlikely to increase it, with the extra potential for some capital growth.

He says: “Over the past 18 months, cash generation in the smaller and mid-cap market has exceeded expectations and many of the companies we hold are in a position to start increasing dividends.

“It is an indication of the balance sheet strength of many of these companies that so many have been able to maintain dividends and are in a position to grow them with or ahead of the inflation rate. There is a growing feeling that operating margins can go above previous levels as companies hang on to the structural cost savings of the past couple of years.”

Taylor notes strong dividend growth from several smaller stocks in recent months, with Domino Printing up by 20 per cent and RBC 13 per cent.
As a small and mid-cap portfolio, the Chelverton fund is more tied into the UK economy than peers, with most large-cap stocks having a bigger portion of their earnings from overseas.

Taylor says he has some overseas earnings exposure on the portfolio but is keen not to overpay. He says: “You can buy UK earnings at 7.5 times with a solid yield or superior overseas earnings on a higher multiple with little yield – the key is getting the balance right.

“The UK economy is slow but as long as we avoid dipping back into recession and growth carries on at 2.25-2.5 per cent, our fund is basically paying investors to wait for recovery with a 6 per cent yield.”

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