Income from small caps

The Interview

In recent years, a number of asset managers have cottoned on to the idea that small-cap investing does not necessarily have to be all about capital growth. The sector can also provide an attractive and diversified income stream, and a number of small-cap funds have been launched with an income mandate. "Imitation is the highest form of flattery," jests Ed Beal of Aberdeen Asset Managers.

Income from small-caps is not a new theme, he maintains. And he should know - his fund, the Dunedin Smaller Companies Investment Trust has long been the highest yielding fund in the AIC's small-cap sector. Its current net yield of 3.5 per cent is almost twice the sector average.

But this doesn't mean that growth has been sacrificed in the pursuit of dividends. The fund is still very much, as its board likes to describe it, "a widows and orphans fund" and while the aim has been to move up the income scale, this has not been done at the expense of capital. Dunedin Smaller Companies Investment Trust's investment objective remains centred around long-term growth - not total return or income.

When Mr Beal inherited the fund at the beginning of 2006 it underwent a fundamental restructuring, with the manager whittling down the fund's 120 holdings to around 45 companies, which he views as "high quality" players that can offer structural growth. He assesses companies based on a number of factors, including the strength of the balance sheet, quality of management and whether there is a sustainable competitive advantage.

Since the restructure, compound annual growth in the dividend has been around 6.4 per cent, well ahead of inflation and reflective of Mr Beal's view that there is no point investing in a company with a high yield if it is not going to deliver growth over the long term.

While growth remains at the core of the fund's investment process, the income story that Mr Beal has been advocating since he took over the fund's reins is certainly compelling. He points to the fact that the majority of income paid by FTSE 100 companies comes from four sectors: oil and gas, banks, mobile telecoms and big pharma.

"These sectors share two unpleasant characteristics: Firstly, they are all subject to some large sector-specific risk that could put the dividend of the whole sector at risk. If the oil price is $60 at the end of this year, then BP and Shell can't afford to make their distributions; if the patent cliff is as bad for the pharmaceutical sector as some are suggesting, they won't be able to make their distributions. And we know what happens to the banks, because we have seen it.

"Secondly, broadly speaking, one or two companies in each sector pay the bulk of the dividends. "In the oil and gas sector it is Shell and BP; in banking it is HSBC and Standard Chartered; in telecoms Vodafone; and pharma is dominated by GSK and AstraZeneca. This means there is immense company-specific risk embedded in the FTSE 100."

Mr Beal adds another point: "There is also the fact that you get around 19 per cent of your revenue declared to you in dollars, which you may or may not find an attractive proposition, but as a UK investor I would rather have my income in sterling and then I can overlay the dollar when I choose to do so."

By contrast, dividends from the FTSE Small Cap index are spread across a number of sectors. "The one sector that has a disproportionately high level of income distributions is support services - and if there is one thing that characterises this sector, it is that it is the dumping ground for companies that don't belong anywhere else," says Mr Beal."So instead of having one or two companies paying the bulk of distributions, you have around 30 companies - which means you have nowhere near the same amount of company concentration and risk. That really is the point. We can deliver income without being as constrained as the big-cap guys," explains Mr Beal.

Mr Beal likes Fenner (one of the fund's top 10 holdings), a leader in reinforced polyment technology, which benefits from strong customer relationships, healthy long-term demand and high barriers to entry. The company also has high overseas earnings. Another top-10 holding is brewer and pub operator Fuller Smith & Turner , which benefits from premium brands supporting good margins and a strong balance sheet. There is also significant hidden value in the company's freehold properties.

The fund also has a number of mid-cap holdings and indeed one FTSE 100 company. "The board takes a pragmatic view on this and feels that if you have done work on a company and you like it, just because it moves from one index to another does not mean you should necessarily sell it," says Mr Beal. He points to Weir Group as an example; now a FTSE 100 company, the fund has owned it since it was a small-cap. This is testament to the fund's long-term investment approach - many of the companies in the fund have been held for over 10 years.

Mr Beal makes the point that he "invests in companies rather than buying stocks" and the idea that underpins this fund is buying good quality companies and making money from them over the long term.

"We're not seeking to build a defensive portfolio - we're seeking to build an understandable, high-quality portfolio. We identify quality first and then start the conversation about valuation," says Mr Beal. "I am not suggesting that we are afraid or unwilling to invest in cyclical companies, but we want to invest in cyclical companies that are able to deliver growth through the cycle."

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