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In search of quality small-cap income

Montanaro UK Income fund manager Charles Montanaro focuses on smaller companies for income but won't touch the Alternative Investment Market
November 18, 2015

Montanaro Asset Management is better known for small-cap growth investing, but the Montanaro UK Income Fund (IE00B1FZRT49), launched in 2006 and managed by Charles Montanaro, focuses on 'quality' companies between £100m and £2.5bn in size.

There has been an increase in the number of funds focused on smaller company equity income in recent years. Managers such as Siddarth Chand Lall of Marlborough Multi-Cap Income (GB00B908BY75) and Gervais Williams of Diverse Income Trust (DIVI) are also happy to invest in the Alternative Investment Market (Aim).

But for Mr Montanaro Aim is a no-go area. "In the long term Aim is tricky - a lobster pot that you can get into but can't get out of," he says. "It suffers from poor liquidity and also poor corporate governance. It is true that there are some good investments on that market, but the returns on those one or two good ones are more than offset by those that don't do well. If liquidity reverses, the risk of Aim performing poorly goes up. So we are much less vulnerable to a down cycle than other funds invested in this.

"And there are plenty of companies we can invest in on the main list. In nine of the past 10 quarters FTSE 250 companies have enjoyed faster dividend growth than the FTSE 100. And smaller companies have strong dividend cover."

For 2015, the dividend cover is 1.7 for the FTSE 100, against 2.06 for the FTSE 250 and 2.19 for the Numis Smaller Companies index. The dividend cover is the number of times a company's most recent dividend can be paid out of its annual earnings.

"Oil and commodity shares have been the problem for large-caps, which have the weakest dividend cover since 2009," says Mr Montanaro. "Dividend cover and dividend growth is much more attractive for smaller companies than large ones, so this suggests smaller company UK equity income should continue to do well."

He also points out that more than 70 per cent of UK stocks (excluding Aim) yielding more than 3 per cent have a market capitalisation of between £100m and £2.5bn.

Charles Montanaro CV

Charles Montanaro is chief executive officer of Montanaro Asset Management and manager of funds including Montanaro UK Income. He founded Montanaro in August 1991 to specialise in analysing and investing in quoted European smaller companies, and has since launched several funds which have in aggregate assets under management of more than €1bn.

He has also worked at MMG Patricof, Dean Witter Reynolds and Drexel Burnham.

Mr Montanaro has an honours degree in Anthropology from Durham University.

Mr Montanaro seeks what he describes as "simple businesses we can understand".

He likes niche businesses in growth markets, in particular non-cyclical ones that benefit from organic self-funded growth and long franchises. He also likes ones with a strong market position, pricing power, high intellectual property, unique selling propositions, high barriers to entry and a sustainable competitive advantage.

"We like profitable companies at sensible valuations," he adds. "And we like good management."

For the equity income fund, he scores the dividend safety of a company against six factors:

■ Growth of the dividend per share over 10 years

■ Net debt to equity ratio

■ Earnings per share volatility

■ Free cash flow cover

■ Dividend cover

■ Analyst view.

The portfolio on average has dividend cover of 1.7 times and the fund currently offers a yield of 3.6 per cent.

Holdings include housebuilder Galliford Try (GFRD), which has a leading position in the affordable housing sector and strong management. Mr Montanaro says it is being driven by population growth and undersupply of homes in the UK, while it offers an attractive dividend yield of 4.9 per cent.

"Housebuilders have never had it so good," he adds. "While house prices have surged, the underlying land prices, which account for 20 per cent of the cost, have stayed reasonably flat as the recent relaxation of planning rules has meant more land is available."

Other housebuilders in the portfolio include Taylor Wimpey (TW.) and Berkeley Group (BKG).

Another area he favours is financials, which accounts for around a quarter of assets. "As we all live longer the need to save and invest for retirement becomes ever greater," explains Mr Montanaro. "This, coupled with a pension system that is becoming mind-bogglingly complex, should play out well for the wealth management industry."

Holdings including wealth manager St James's Place (STJ), meanwhile, should benefit from regulatory changes such as the retail distribution review (RDR), the move from defined benefit to defined contribution pensions, the ageing population and the growth in its partnership network. It has a yield of 2.63 per cent.

As people live longer they also have more time for leisure and eating out so portfolio holdings include Domino's Pizza (DOM), Cineworld (CINE) and Restaurant Group (RTN).