Don’t ignore smaller companies for income

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

While the UK market is a good hunting ground for income-seekers, that income is often concentrated in a handful of stocks and sectors. “A small cap allocation can help to diversify this, and the investment trust structure has unique features that makes it attractive to income seekers” says Roland Arnold on the BlackRock Smaller Companies Trust.

The UK stock market has a well-deserved reputation for income. There is an established dividend culture among many UK companies and the FTSE All Share outpaces many of its global peers for yield.1 In 2022, UK companies paid out £94.3bn in dividends, an 8% rise on the previous year. This was led by a strong performance from the mining and financials sectors.2

However, UK income strategies focused on larger companies often have a diversification problem. The recurring criticism is that UK income funds are concentrated in a handful of companies and sectors.3 This is unarguable. In 2022, £1 in every £6 paid in dividends came from the mining sector alone.4 The top five companies – Rio Tinto, Shell, British American Tobacco, HSBC and Glencore – accounted for 28% of all dividends paid.5 Too often, UK dividend strategies are narrowly focused on a handful of mining, energy and financial companies.

This can be problematic. The mining sector, for example, can be sensitive to shifts in the global economy. Mining dividends had already started to decline in the second half of 2022 and are forecast to drop further in 2023.6 Banks saw dividend growth of over 50% in 2022, but dividends have yet to return to pre-pandemic levels.7 It is a reminder of the importance of a diverse dividend stream.

The small and mid cap sectors are often over-looked by income investors, and yet can provide a potential solution to this diversification problem. There are compelling yields available from UK smaller companies, with the MSCI UK Small Cap index currently yielding 3.1%.7 compared to 2.1% for the MSCI World Small Cap.8

Small caps are, by their nature, more diverse. There are more of them – almost 1,500 included in the Numis Smaller Companies plus Aim index (excluding Investment Companies), the benchmark for the BlackRock Smaller Companies Trust – and they are spread across multiple sectors, rather than being dominated by just a handful. The small cap universe includes industrials, technology, property and healthcare.9

They are also faster-growing. At a time of higher bond yields, income seekers have greater choice. The advantage of equities over bonds is that dividends can grow over time, whereas the income from a bond is static. This may give investors greater protection from inflation. Smaller company dividends could deliver this growth.

In the BlackRock Smaller Companies portfolio, we have invested in companies where the initial dividend yield looked unremarkable, but the growth in dividends over time has been compelling for many of our companies because of their cash generative business models, which allow this cash to be deployed in capital expenditure, acquisitions or dividends. The trust has now increased its annual dividend every year since 2003 with an annualised increase in dividends paid since this date of 12.2%.10

To find the best smaller companies that can grow their income over time, we focus on certain factors that indicate a company’s quality. Companies need strong cash flow, for example, a sound business model, strong competitive advantages and a capable management team to sustain and grow their payouts to investors. These are all at the core of our process on the BlackRock Smaller Companies Trust.

The investment trust structure has unique features that makes it attractive to income seekers. In particular, it allows us to reserve income in buoyant times (by holding back up to 15% of the income received each year) to boost distributions to shareholders in leaner times, giving us the flexibility to grow our payouts to investors over time. It is notable that the industry body for investment trusts (the Association of Investment Companies (AIC) maintains a list of ‘dividend heroes’, being investment companies that have increased dividends over a sustained period of time. The AIC released an update on 14 March 2023 noting (inter alia) that BlackRock Smaller Companies is leading a next generation of dividend heroes, having increased its dividend for 19 consecutive years.11 As of 31 August 2022, the company had £684m12 in distributable reserves, including revenue reserves of £17.9m.13

While the UK could optically be a great place to look for income, investors need to ensure that income is properly diversified and small caps could provide a great balance.

Risk Warnings

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

Counterparty Risk
The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.

Diversification Diversification and asset allocation may not fully protect you from market risk

Equity risk The value of equities and equity-related securities can be affected by daily stock market movements. Other influential factors include political, economic news, company earnings and significant corporate events.

Gearing Risk
Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.

Investment strategy There can be no guarantee that the investment strategy can be successful and the value of investments may go down as well as up.

Liquidity RiskThe Fund's investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair.

Smaller Company Investments
Shares in smaller companies typically trade in less volume and experience greater price variations than larger companies.

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