Too many investors find themselves concentrated into dominant sectors and herded into mega-caps. Alan Clifford, manager of the Lazard UK Income fund, says it is time for change.
It is no great secret that the UK equity market is highly concentrated. However, equity income fund managers still need to deliver a premium yield, adding to the problem of portfolios with sizeable overweights in a limited number of sectors and stocks.
It is easy to see why this occurs: half the FTSE All Share yield comes from just ten companies and 87% from the FTSE 100. Of the 40 sector groups represented in the UK market, five contribute 52% of the yield.
Concentration, being the opposite of diversification, carries inherent and familiar risks. While we often see large companies as steady, reliable dividend payers, their income is not guaranteed: about a third of the current FTSE 100 constituents have suspended or cut their dividend payments to some degree in the past decade.
If the cap fits: How small- and mid-caps play a big role
Unpredictable stock-specific events can be a painful lesson to investors who are reliant on dividend payments for income. BP’s dividend suspension in 2010, following the Macondo spill, serves as a perfect example.
Among FTSE 100 companies, many that help equity income investors achieve their yield ambitions are viewed as defensive in nature: tobacco, pharmaceuticals, utilities and telecommunications all feature heavily. While this defensiveness is attractive in times of turmoil, it also tends to mean such companies will lag a rising equity market.
Diversity of income
We believe taking an all-cap approach to income investing offers greater diversity of income while also providing better opportunities for dividend growth and ensuring the equity market exposure is balanced with the desire for income.
By looking further down the market cap spectrum, investors can access a wider range of sectors and companies, many of which are underrepresented among large-caps, such as support services, travel and leisure, and financial services. The chart shows the difference in sector weightings that arises between the large-, mid- and small-cap parts of the UK market.
Moving down the market cap spectrum increases the total number of companies whose yield exceeds that of the market. About 41 companies in the FTSE 100 offer a premium yield to the market as a whole, with an additional 134 in the mid- and small-cap part of the market.
In fact, about half of the UK companies paying a premium yield have a market cap of less than £1bn. Not only are there more companies already paying an attractive dividend but there is increased scope to identify those which may be initiating, reinstating or increasing their dividends, adding to this income opportunity set.
Another significant benefit is that small- and mid-caps in the UK also have a track record of delivering far superior dividend growth relative to the FTSE 100.
Many of these companies are growing at a much faster pace than larger businesses and, as they approach maturity, can increase their payouts to investors. Dividends per share of the FTSE 100 have increased by around 70% over the past decade, compared with 140% to 150% for the FTSE 250 and FTSE Small Cap indices.
So, why not invest exclusively in small- and mid-cap stocks for income, then? Firstly, referring again to the chart, there are a number of sectors underrepresented in that part of the market.
Some of these – tobacco, for instance – are substantial sources of dividends. Smaller pharmaceuticals businesses also tend to be in a growth phase and do not yet deliver the level of yield paid by GlaxoSmithKline or AstraZeneca.
In very challenging market conditions, such as 2008, small- and mid-cap stocks can also suffer disproportionately and can display greater volatility. Bearing in mind that 87% of the FTSE All Share’s income comes from FTSE 100 companies, equity income investors ignore this part of the market at their peril.
Moving down the market cap spectrum brings other challenges. This part of the market is much less widely researched, requiring specialist skill sets and dedicated resources. When investing in smaller companies, patience is a virtue.
The lack of newsflow between reporting dates can mean long periods where share prices can make little progress but dividend payments do provide some support during these periods.
Another important issue is liquidity. Lower trading volumes among smaller companies mean individual position sizes must be carefully balanced with fund size. Positions which are too large can create liquidity problems; too small and they can have little impact on performance when their upside potential is realised.
The principle of diversification is at the heart of investing, yet many income investors find themselves concentrated into certain dominant stocks and sectors and often herded into mega-cap defensives.
We believe taking a multi-cap approach can help reduce the negative impacts of the UK market’s concentration issues, as well as providing the benefits of faster dividend growth among smaller companies, and lead to an attractive total return.
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