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A Diversified Approach to Income Can Pay Dividends

Updated: May 17, 2022

Income continues to be the principal concern for many investors in the UK - both in the run-up to and throughout retirement. Reinvested dividends can boost total returns and help supplement post-retirement income. When you also consider that many investors are still looking for yield at a time when interest rates remain near historic lows, and central banks appear in no rush to take interest rates higher, the ability to receive income in the form of dividends will be an attractive prospect for many investors.

"Venture into the mid-cap space, and you can find plenty of decent yielding stocks"

Market wisdom generally has it that the dividends paid by FTSE 100 blue-chip stocks are more secure than those paid by small and medium­ sized listed companies. Thus, thinking intuitively, it would make sense to buy and hold these stocks over medium-sized companies for the more stable and consistent income on offer. On the contrary, however, this article will highlight why also favouring listed mid-sized payers, instead of merely the large-cap companies, can - and likely will - pay dividends.

Much has been written about dividend concentration among UK large-cap stocks of late. According to an analysis last year by the UK Dividend Monitor, the UK's largest dividend payers - BP, HSBC and Shell - comprised almost a quarter of the total FTSE 100 pay-out, despite none of these companies increasing its pay-out in at least three years in dollar terms. To further compound matters, analysis by AJ Bell has shown that merely 10 stocks are responsible for 54% of total FTSE 100 dividends.

These companies - the major source of the FTSE l00's robust dividend yield of some 4.50% - reflect the significant concentration risk investors face and should be a concern for those investors with portfolios exposed to UK large-cap income funds, which are likely to include a vast proportion of retail and wholesale investors.

In fact, some current forecasts point to an expected FTSE 100 yield as high as 4.8% in 2019. With the largest contributions commonly coming from just a handful of the usual large-cap suspects, the risk of concentration for the investor increases. That said, although dividend concentration is prevalent in the FTSE 100, it is not particularly out of line with history. Analysis of Morningstar data, for example, has indicated the average number of holdings in UK equity income funds has remained consistently around the 55-mark since 2008, suggesting the UK dividend market itself has been more condensed and concentrated for a substantive period of time.

Fear not, though, for help is close at hand. Venture into the mid-cap space, and you can find plenty of decent yielding stocks. According to recent analysis from Morningstar, for example, ITSE 250 companies are forecast to pay a yield as high as 3.3% to investors this year. A focus on mid-caps could be advantageous, principally because over time mid-caps tend to perform better than large-caps, both on a total return and a volatility-adjusted basis.

This is not the only reason, however. Mid-caps are under­ researched, so stock-picking opportunities abound. Indeed, certainly more so than in the blue-chip universe, with much focus on the leading payers as managers battle to seek out the best income stocks - according to one line of thought, the concentration has come about over the past decade because large-cap, quality growth stocks have outperformed. Furthermore, as mentioned, you can find decent yields in the mid-cap sector.

There are UK mid-cap stocks yielding upwards of 7% compared with the 2.82% current general average yield for FTSE 250 stocks. You may think by going for mid-caps over large you are sacrificing dividend cover or income sustainability, but this is not the case – the difference between the two universes is negligible.

Dividend cover for FTSE 100 stocks is 1.9 times compared with 1.7 times for the mid­ cap universe - the first time in three years, in fact, that FTSE 100 dividends have been more sustainable than those generated by the FTSE 250.

In short, then, looking at medium-sized companies can pay dividends for investors. Dividend risk may be heightened through a bias toward the leading market capitalisation companies that have a history of paying out the most, and consistently so.

Naturally enough, a good number of these companies make up the core of most income fund portfolios. By seeking income-paying mid­ caps, you can effectively de-risk this concentration in portfolios while also diversifying sources of income.

Additionally, by dipping into the mid-cap universe, investors also benefit from diversification away from certain concentrated sectors - after all, many of the leading blue-chip payers operate in the same sectors, such as financials, mining, and oil.

Blue-chip stocks may have paid out the most income over the past five years, but investors should also be interested in portfolios that can grow their pay-outs over time - and we believe mid-caps present a greater potential to do this. Growth can be somewhat less likely among blue-chip stocks. In the UK, we have always tended to focus on mid-caps rather than larger stocks, finding there is more opportunity to unearth 'hidden value' for investors in this universe.

A search for income does not need to be confined to equities though. Dividing your investment money between, but also within, the various asset classes is crucial when building a diversified portfolio. As income-seeking investors, we view diversification as key to defending against dividend risk. There are many companies in our investment universe that produce either a decent yield or the prospect of dividend growth, or indeed both, but it is crucial investors look beyond the traditional sectors to find them. Alternative assets and alternative companies - what we term 'specialist assets' - can also be a source of consistent cashflows as well as of diversification.

Multi-asset approaches can do the job on behalf of advisers and their clients, with a professional fund manager deciding the split of investments and ensuring the fund is not overweight in one specific area - for example, leading dividend payers that build up concentration. All things considered, therefore, the merits of a multi­ asset, diversified, approach to generating income are clear.

Published in Professional Investor

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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