Should investors continue to favour large companies capable of returning cash to them today as dividends – and perhaps through buying back their shares – or is there a case for looking outside of the large and mega caps?
Dividends in smaller companies have bounced back since incurring some of the deepest cuts during the pandemic and enjoy higher cover, but Graham Ashby, manager of the Schroder Multi-Cap Income fund, admits they are, in general, more volatile.
He argues that opportunities for growth can be less well appreciated among the smaller companies. And the ‘sell-side’ analysis for many smaller companies can be sparse.
“One of the reasons to invest further down the capitalisation spectrum is to find more interesting companies where dividends are more sustainable,” Ashby says.
‘Better growth over 10 years at the expense of the short-term’
The lack of analyst interest explains part of the attraction of games and crafting company Games Workshop, according to Ashby. Given it is covered by just four sell-side analysts, “it’s not particularly well-followed,” he adds. “But cash flow is coming through year in, year out and, to the company’s credit, when it builds up too much, they return it to investors.”
The company’s fantasy worlds have the potential to become global franchises, Ashby believes. It is licensing intellectual property (IP) to specialist video games producers and major entertainment groups, including the Walt Disney Company.
“We have been encouraging them to reinvest as they have a huge opportunity for growth – I’d take better dividend growth over 10 years’ time at the expense of some growth in the short term,” Ashby says.
Alan Dobbie, co-manager of the Rathbone Income Fund, makes the point that despite the ban on bank sector dividends and huge cuts from the oil majors, payouts from FTSE 100 companies were much more resilient than those from smaller companies in 2020. But, perhaps unsurprisingly, smaller companies bounced back at a faster pace as the economy reopened in 2021.
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So, does he agree with Ashby that there are good reasons to invest further down the market cap spectrum?
“As long as the liquidity is adequate, company size does not form a key input into our investment decision-making. We’re comfortable investing across the market-cap spectrum.”
He adds: “While smaller companies often have greater growth potential, by virtue of their size, this should be reflected in higher valuations. From time-to-time valuation anomalies can exist in certain areas of the market and it would be foolhardy not to be alert to these opportunities.”
Focus is on the headline, not the potential
Andrew Paisley, head of smaller companies at Abrdn, says there is a temptation for investors to focus purely on the headline dividend yield of a stock when looking at its income generating potential. However, that misses an extremely important dynamic when considering where to look for income – namely the rate of dividend growth being exhibited by the company.
“Many large cap stocks have optically attractive dividends, but can be static or low growth reflecting the fact that large caps are often more tied to the general level of economic growth.”
He adds: “Many smaller companies by contrast are growing either in markets which themselves are growing much more rapidly than the overall economy or are taking share from larger less nimble competitors.”
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This faster rate of profit growth can translate into superior dividend growth, something that should not be forgotten when looking to invest for income, Paisley insists.
“As such, we believe that looking at high quality, growing smaller companies can be an effective way to deliver a satisfactory and growing level of income over time for investors.”
Less diversified and more economically sensitive
Mark Whitehead, fund manager, Sanlam Sustainable Global Dividend Fund takes a different view.
He suggests investors should continue to consider large companies that can grow their revenues, earnings and cashflows, even in more difficult operating environments, while maintaining their asset bases and re-investing into future growth opportunities.
These attributes, he argues, combined with prudent balance sheets, liquidity management and sustainability leadership, offer the potential of superior returns to shareholders. These qualities are the hallmark of a successful dividend paying company.
“We are able to invest in very interesting large companies that are producing sustainable dividends, so why take a higher level of risk by going down the market cap spectrum?”
He continues: “Smaller companies can be less diversified and more economically sensitive to particular countries or regions which can lead to more variable outcomes to shareholders. Many smaller companies are also lagging their larger counterparts that are taking their environmental and social responsibilities more and more seriously.”
