At the end of last month's column, I promised to explain why Dunedin Smaller Companies Investment Trust (DNDL) had been introduced to the Income portfolio in July. The case for income from UK blue chips and overseas has been made in previous columns and elsewhere, and is now well established. But investors will also benefit from exposure to small cap dividend stocks – this potential has tended to be ignored, and yet is being enhanced by the discounts available on certain investment trusts.
The case for small cap income
The important role dividends play when it comes to profitable investing is well established. Over the longer term, securing and then reinvesting has been key to profitable returns, as the Barclays' Equity Gilt Study keeps reminding us in its annual report. £100 invested in UK equities at the start of the 20th century would be worth just £180 by 2011 in real terms if dividends had not been reinvested. The figure rises to a staggering £24,133 if they had. Repeating the exercise since WW2 produces figures of £255 and £4,370 respectively.
This phenomenon is not restricted to these shores. Figures from Standard & Poor suggest that US dividend payers outperformed non-payers by 3 per cent a year between 1980 and 2005. The cumulative effect of this outperformance has been significant.
But given the lacklustre economic outlook, particularly in the West, might this not be the time to be picking dividend payers? After all, this recession has been caused by high and unsustainable debt levels. This is true of governments and consumers, but not of companies. Indeed, balance sheets are in robust health. Concerned by the outlook, companies have been cautious, cutback on capital expenditure, and conserved cash.
Dividends have benefitted as a result. A study by Capita Registrars suggests that dividends paid during the first half of this year were 20 per cent higher than a year ago. And the £41.4bn paid out convincingly beats the previous high of £34.5bn paid during the first half of 2008.
Half of this year's increase came from ordinary dividend increases, whilst the other half came from one-off special payments. As economies continue to flatline, such payments will probably continue as they allow managements to address shareholder demands for better payouts without locking the company into what might become unsustainable dividend policies going forward.
This good news about dividends is not restricted to the large, blue chips. Smaller company balance sheets are also robust. And there is a far greater universe of stocks from which to generate income. The top 15 dividend payers in the FTSE 100 account for two-thirds of all FTSE income. The top 15 dividend payers in the FTSE small cap sector account for just 30 per cent of the sector’s income.
Cuts to BP’s dividend showed the benefit of diversifying one’s equity income exposure. The small cap sector abounds with opportunity. The scope is enormous for good fund managers to find excellent under-researched smaller companies with decent and growing dividends. Wise investors will capitalise on this overlooked potential.
Portfolio changes
This is where Dunedin Smaller Companies trust (DNDL) comes in. Ed Beal, its well respected manager, has generated a good track record – handsomely outperforming its FTSE SmallCap (exc investment companies) benchmark over one, three and five years.
DNDL presently yields around 3.5 per cent based on last year's dividend of 4.85p. Its 10-year dividend record amounts to an annual compound increase of 6.5 per cent. This looks sustainable going forward given that companies with strong business models and good dividend prospects are sought, whilst revenue reserves come in at around 6p. Speaking with Ed, around half of the portfolio’s earnings are generated overseas, with good exposure to the faster growing emerging markets.
The trust is not geared to any extent and presently stands on a discount of 10 per cent - which has closed in somewhat during the last month. This compares to a sector average of between 15-20 per cent. So one could argue it is not cheap. But I cannot think of many equity yield trusts with good track records which stand at discounts of 10 per cent. Most are on premiums to NAV, except some of the more heavily geared commercial property trusts.
Furthermore, as regular readers will know, I very much question the deep discounts accorded to the smaller company trust sector in general. Despite all the doom and gloom, once again the FTSE SmallCap index has outperformed year to date. I believe this outperformance will continue for reasons most recently outlined in my column 'The smaller company opportunity' (9 March 2012). Both portfolios have been overweight smaller companies relative to benchmarks since inception, and will continue to be so.
Otherwise, there were no changes to either portfolio during August.
