Lowland: small and mid-caps for…income?

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The UK dividend seeker’s dilemma: avoiding too much income concentration. The concept surrounds a fairly well-penned story in the press about how the vast majority of the UK’s dividends are paid by a small cadre of the top FTSE 100 companies: the top 20 companies hand-out 70% of all UK dividends paid; the top 10 pay 50%; the top five pay 35%.

But what choice do we have? This is the structural nature of the UK’s stock market.

Actually, there is choice, and it’s a great argument for the professional oversight of good active fund managers. They are not forced to overly concentrate their portfolios in pre-determined amounts according to index weightings; they are free to balance perceived risks and extract income from a variety of sources as they see fit.

Laura Foll, Co-Fund Manager of the Lowland Investment Company – a UK focused investment trust that invests in all sizes of companies to try to grow your capital as well as provide a good level of income – points to how the issue of structural income concentration is dealt with in the portfolio: diversifying the income stream through small and mid-capitalisation stocks, ordinarily unloved by the income seeking portfolio manager but with the potential of being great yield stories.

 

An unexpected journey

The small and mid-cap space is usually reserved for the growth investor – those seeking above average levels of earnings growth, which they believe will translate into strong share price returns. Large caps have tended to be more associated with income seekers.

The income rationale behind larger businesses is that strong and stable companies with entrenched market positions and experienced management tend to be very focused on creating shareholder value and therefore delivering steady or rising levels of dividends.

But Laura points to the fact that there are plenty of businesses further down the size scale that engender these qualities. In fact, she says, in the Lowland portfolio they are some of its highest yielding stocks.

Looking at the broader evidence, the FTSE 250 – the UK’s mid-cap market – is forecast to pay a 3.0% yield this year; the FTSE Small Cap is forecast to pay 3.1%. This compares to the higher yielding FTSE 100, which, although yields a higher 4.2%, has a lower level of dividend cover.

Because of their lack of liquidity, mid and small cap stocks are often under-researched by analysts. Less coverage means less information feeding into the stock market and the share price, giving the savvy investor a greater chance of uncovering undervalued stocks with attractive yields.

Laura points to the following as great examples of high yielding stocks from lower down the market-cap scale, where small-cap is defined as a company worth less than £500m. Please remember though, these are portfolio stock examples and not recommendations to buy.

 

Motoring ahead – Redde

When your car breaks down or you’re involved in an accident, a few things are crucial in rectifying your situation: you need to get the car fixed and pay any legal or medical expenses that may need covering. You also need a replacement car for the interim. Redde assists the insurers with a few of these jobs – running fleets of courtesy cars and operating repair garages.

The business – around £450m in size – is proving to be a success: increasing market share, which in turn is resulting in strong earnings growth and dividend growth. Currently it’s yielding 6.6%.

 

Suited to all occasions – Moss Bros

Moss Bros leads the pack in the UK for branded suits. Its journey since the financial crisis has been one of improvement and change. Years of underperformance made way for new management and a shake-up of the product range, disposals of non-core assets, and store refurbishments. The changing nature of the competition also helped – the quality of suits in rivals M&S and Next has slipped.

All-in-all it is a niche and profitable business with above-average retail sales growth relative to its marketplace and a healthy dividend pay-out, which is propped up by a strong net cash balance sheet in the event of a downturn.

It’s worth about £100m and currently yields 6.1%.

 

A market for convenience – McColls

Head down to your local shops and you might notice a McColls convenience store or newsagents. They’re a growing presence, at around 1400 stores. Convenience stores are one of the higher growth areas of the food market with less cost pressures than their supermarket cousins.

Recently, management have wrapped up a very good deal for the business – buying 298 stores from Co-op, enabling them to exert much greater buyer power and cost savings on the goods purchased for their stores. The product range has also improved over the past five years and they’ve been gradually switching the mix from lower margin tobacco-driven newsagents to higher margin convenience stores with fresh produce.

The business is valued at around £90m. Its current yield is 5.1%.

 

Let’s not tar with a brush

The concentration of income in the UK equity market has led the Lowland Investment Company’s fund managers to seek out lesser known sources of dividends to diversify the portfolio’s revenues. Exemplified in some of its holdings, attractive yields can be found where many an income manager would not look – in small and medium sized businesses. This may give the UK income seeking investor the chance to depart from the status quo of large-cap driven dividends.

 

 

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