Small companies, big dividends

The problem is exacerbated by the rising number of private investors looking for income from shares. So, with an ever larger port of capital to invest, many managers are being forced to take a wider view and seek income from overseas, where more and more companies are starting to understand the appeal of the dividend to their shareholders.

Others are looking further down the index. But while there are plenty of companies in the FTSE that offer yields in excess off the market average of 3.6 per cent, they simply aren't big enough and there aren't enough of them in aggregate to absorb the huge torrent of money that's gushing their way.

Mid cap misery

For the average private investor, that's less of a problem, because we don't have such large amounts of capital looking for a home. That means the liquidity of smaller shares is generally more than enough for us to trade in and out of positions easily.

But anyone thinking about following in the footsteps of some fund managers down into the FTSE 250 should tread carefully. Unlike the giants of the FTSE 100 that do much of their trade overseas, the FTSE 250 is made up of companies that are highly dependent on the fortunes of the still-troubled UK economy. If not confirming fears of a double-dip recession here, recent comments by Kate Barker of the Bank of England's Monetary Policy Committee certainly suggest that the recovery could stumble at the very least this year.

That's reflected in consensus earnings expectations for 2010. While the FTSE 100 is expected to post an earnings gain of 49 per cent this year, helped by sterling weakness, the FTSE 250 will see earnings rise by an anaemic 9.4 per cent this year. That translates into a miserly 2.8 per cent yield, against the 3.6 per cent prospective income return from the larger companies index.

Of course, the mid-cap index isn't without its dividend heroes. Indeed, 45 FTSE 250 companies yield in excess of the current 10-year gilt's 4.06 per cent return - although we know at least one of them, SIG, is unlikely to pay a dividend this year. Stripping this out and applying a minimum dividend cover of two times gives us 16 companies, most of which look astonishingly cheap on a forecast PE basis. Some may say too cheap, suggesting the market is expecting problems - but it's interesting how many companies that pop out of this screen are currently on the Investors Chronicle's buy list, including Dairy Crest, Greene King and N Brown.

Not so dinky dividends

The main advantage that private income seekers have over their institutional counterparts is their ability to think really small when it comes to dividends and target returns from even the lowest reaches of the market.

And although smaller companies lack the investment-grade status of blue chips, the possibility of finding a potentially a mis-priced gem more than makes up for it, as I found when I crunched the numbers. Of the 50 companies in the FTSE Small Cap index with trailing dividend yields in excess of our target gilt rate, 22 cover the dividend more than twice, of which 19 are trading on forecast PE ratios of less than 10.

Heading further into the depths of UK plc, the fledgling index adds another eight companies that meet our yield and cover criteria. The Aim market adds another 64 companies yielding above our gilt rate and 25 that meet our dividend cover requirement too.

Of course, some of these companies are likely to be more reliable payers than others, and that's very clear in the somewhat misnamed Fledgling index, which misleadingly suggests these are companies waiting to take off. Molins, for example, may be yielding nearly 9 per cent, but as Mr Bearbull - who has followed the company's struggles for many years - points out to me, this "comes and goes."

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Think dividends for growth

Gerard Lane, an equity strategist at broker Shore Capital, has taken my analysis a stage further. His analysis of the drivers of small-cap share price performance has found two indicators which have historically led to outperformance. One dividend yield - and the other is return on equity (RoE).

That RoE is a good predictor of upside isn't really a surprise - it suggests high quality, high growth companies, in an index generally seen as more risky, and is Mr Lane's preferred measure. But dividend yield is less intuitive an indicator, because we tend to think that high yield equals low growth.

Yet the back-tested numbers speak for themselves. Over the past 10 years, the top twenty yielding companies in the small cap universe have outperformed the bottom twenty by a massive 300 per cent in absolute terms. It works on a shorter timeframe, too - in the last year, the MSCI value index has returned 88 per cent, against a 65 per cent return for the growth index. "People invest in the small cap arena for growth but the total return profile means that they should invest in small cap for value," Mr Lane argues.

Shore's value stocks by historic yield

Source: Shore Capital Stockbrokers

Shore thing: historic return on equity

Source: Shore Capital Stockbrokers