Reap hidden gems with PFS Chelverton UK Equity Income

"This is a result of our search for funds with a smaller companies bias that are not capacity constrained, and our keenness for income generation in a low-yield environment," says Mick Gilligan, head of research at Killik. "It is increasingly important, when searching for yield, to consider the potential for income to grow. A carefully selected portfolio of UK medium and smaller companies should provide better prospects for growth, of both income and capital, than that of the wider stock market on a long-term basis."

Targeting smaller companies for equity income is also useful for diversification as many UK equity income funds have similar top 10 holdings and sector biases. PFS Chelverton UK Equity Income only has about £70m of assets under management, which allows it to invest in small companies without holding a large percentage of their shares.

PFS Chelverton UK Equity Income is among the top five performing UK equity income funds over one, three and five years. It also beats the FTSE Small Cap index over those periods, and has an attractive yield of 5.58 per cent.

The fund aims for a progressive dividend stream and long-term capital growth. Its managers, David Horner and David Taylor, look for companies with a high initial dividend yield that can grow its income in excess of inflation on an annual basis over the long term.

The fund invests in UK small- and mid-cap equities and Alternative Investment Market (Aim) shares which have a yield of at least 4 per cent on a 12-month view. Its managers say opportunities exist in this part of the market as these high-yield stocks tend not to be bought by small-cap growth managers and are too small for most equity income funds.

PFS Chelverton UK Equity Income's managers target the following:

■ a high and stable yield with no expected dividend growth over the short term but potential to increase;

■ high-yield recovery when a stock has fallen to where cash-flow prospects are not reflected in the price; and

■ a steadily growing dividend where the ability to consistently increase dividend payments in real terms is not reflected in valuations.

They consider the last category the most compelling opportunity as companies that do this are re-rated over the longer term.

The fund's managers assess the ability to pay a dividend by analysis of cash flows and balance sheets, and regular meetings with management.

Smaller company dividends are more at risk from cuts in a severe economic downturn, but PFS Chelverton UK Equity Income's managers' focus on cash flow, experience in the small-cap space and regular meetings with company management should help to mitigate any drop in the income level due to dividend cuts.

The fund has a total expense ratio (TER) of 1.8 per cent which is above the typical open-ended fund which charges around 1.6 per cent, but as it has a specialist mandate – smaller company equity income – and has delivered strong positive returns, this is reasonable. So if you want to reap hidden UK equity income gems and diversify your portfolio, this fund is worth consideration. BUY.

Source: Morningstar & *Chelverton Asset Management

Morningstar as at 29 April

Top 10 holdings as at 31 March 2013

Source: Chelverton

Sector breakdown as at 31 March 2013

Source: Morningstar