The spectre of concentration risk continues to hang over the UK market, with the top 10 dividend payers expected to account for 55 per cent of payouts in 2018, a slight increase on last year.
This is a problem, as if any of these stocks were to cut their dividend, it would have repercussions for the majority of people who rely on the income from their investments, such as pensioners.
Investors don’t need to look too far for examples of where this happened in the past – RBS and Lloyds suspended their dividends after the financial crisis in 2008, while BP did the same following the Gulf of Mexico oil spill in 2010.
However, nor do they need to look too far for a potential solution to their problem, as a simple glance at the IA UK Equity Income sector shows the best performer over 10 years, Unicorn UK Income, holds none of the FTSE’s largest dividend payers in its own list of top-10 holdings.
The fund has made 279.02 per cent over the past decade, compared with 102.41 per cent from its sector and 98.08 per cent from its FTSE All Share benchmark.
Performance of fund vs sector and index over 10yrs
Source: FE Analytics
Chelverton UK Equity Income, in second place, made 212.88 per cent.
Simon Moon and FE Alpha Manager Fraser Mackersie, who head up the Unicorn UK Income fund, describe their process as “absolutely bottom-up”, searching for companies that are cash generative with strong balance sheets and that are able to pay dividends. They must also be exposed to a strong end market.
To find these, they run a weekly screen highlighting profitable companies with a yield of more than 3 per cent and a dividend cover of 1.5x, removing stocks in sectors that don’t lend themselves to their approach.
“We don’t invest in oil & gas, mining, pharma and biotech,” said Moon. “Basically anything that when you go further down the market cap scale is less likely to deliver the predictable cashflows we like.
“We have never broken that to buy something. I can’t think of one, anyway. We love small companies. But there are some tricky areas within smaller companies and by excluding those it makes our lives a lot simpler.”
Unicorn runs a VCT, the Outstanding British Companies fund – which focuses on AIM stocks – and a dedicated smaller companies fund, meaning that by the time a stock has reached a stage of maturity where it is suitable for inclusion in Unicorn UK Income, the managers have often been aware of its progress for a number of years. Mackersie and Moon said that although they begin with a screen, the way to add value in this area of the market is by going out and meeting with these companies’ management teams – and that they will often make as many as 400 visits a year.
“The level of corporate access we get is really fantastic and if we want to go and see any of them on the ground, we do,” Moon continued. “Last year we saw Marshalls – a supplier of block paving – five times. Two of those visits were us asking to see different parts of the operation. They were very open with that.
“The guys running the operation give you a really good level of insight into the meat and bones of the company. You get a feel for these things, whether it is a well-run business or not.
“We like to see how the CEO and CFO work together, whether they have an equal relationship. We like to watch how people operate. It is a bit of a soft skill, watching people, it is undefinable. You wouldn’t get a broker note saying that sort of thing, but it is very important.”
Much of Unicorn UK Income’s outperformance came about under the tenure of former manager John McClure. Since his death in June 2014, the fund is still ahead of its sector, albeit by less than 1.5 percentage points.
Performance of fund vs sector and index under managers' tenure
Source: FE Analytics
Moon and Mackersie have maintained the same process since then, saying the only tweak they have made is investing more in tech-focused companies, which McClure was less keen on. However, they pointed out many of these businesses have “grown up a bit” and are now more cash generative and more likely to pay a dividend.
Looking ahead, Moon is optimistic that small caps can continue to outperform – pointing out that while they did well last year, they are still sitting on a significant discount to the rest of the market.
“You have this strange dynamic where you had a really strong reporting season in the autumn after the referendum vote and everyone thought it was a blip,” he said.
“Then the following reporting season was very strong and people realised it wasn’t a blip and companies were performing well. Then you had another strong season and we fully expect another strong one this autumn as well.
“Last spring was where you saw a re-rating for the first time – they have had earnings growth, so they are not expensive, they just got re-rated from a very low base.
“All I am wishing for in 2018 is a quiet year, one where there isn’t a massive blow-up.”
Moon and Mackersie’s fund is not the only one in the IA UK Equity Income sector to show the benefits of investing further down the market cap scale for income. A recent article on FE Trustnet showed that the most consistent fund in the sector over the past decade – Royal London UK Equity Income, which has beaten the sector average in nine of the past 10 calendar years – also has a small- and mid-cap focus.
Unicorn UK Income is yielding 3.86 per cent. An investor who put £10,000 into the fund 10 years ago would have earned £6,886.98 in income alone over this time.
The fund is £673.1m in size and has ongoing charges of 0.81 per cent.