UK Smaller Com­pa­nies – an al­ter­na­tive to the in­come dilemma?

The Week - - City -

Over the past few years the need for in­vestors to in­vest for in­come has been a hot topic. As a na­tion we are living longer, there­fore we need to make our sav­ings and in­vest­ments work harder for us in or­der to fund a longer re­tire­ment. In­ter­est rates are at his­tor­i­cally low lev­els and have been for al­most a decade1 and there­fore re­turns on cash sav­ings are al­most non-ex­is­tent, and let’s not for­get the im­pact of in­fla­tion erod­ing sav­ings held in cash. Mean­while wages are strug­gling to keep pace with in­fla­tion, fur­ther im­pact­ing the amount of money that peo­ple have at their dis­posal to put away to fund their fu­ture re­tire­ments.

Equity In­come funds, which have an ob­jec­tive to de­liver in­come to in­vestors, have to some ex­tent been pre­sented as a so­lu­tion to the in­come prob­lem fac­ing in­vestors in the cur­rent en­vi­ron­ment. With the av­er­age in­come fund in the UK Equity in­come sec­tor yield­ing 4% this seems like a sen­si­ble so­lu­tion. How­ever, many of the largest holdings within equity in­come funds tend to be ‘bond proxy’ type com­pa­nies, char­ac­terised as com­pa­nies that have de­liv­ered con­sis­tent but mod­er­ate earn­ings growth, which are of­ten larger more de­fen­sive com­pa­nies. Given these typ­i­cal char­ac­ter­is­tics, it might seem a lit­tle odd to be dis­cussing a UK small-cap trust and the need for in­come in the same breath, as smaller com­pa­nies are more of­ten as­so­ci­ated with the po­ten­tial to gen­er­ate cap­i­tal growth rather than in­come.

Smaller com­pa­nies are of­ten thought of as young, im­ma­ture busi­ness mod­els that may be en­ter­ing new mar­kets, adapt­ing to chang­ing mar­ket dy­nam­ics or lead­ing tech­no­log­i­cal change, try­ing to es­tab­lish them­selves among the com­pe­ti­tion and take mar­ket share. There­fore, and rightly so, the pri­or­ity for many of these com­pa­nies is in­vest­ing for growth, and it is as­sumed that re­turn­ing cash to share­hold­ers is not high on the list of pri­or­i­ties for a smaller com­pany. While many of these state­ments are true and are in part many of the at­trac­tions of in­vest­ing in the smaller com­pa­nies’ uni­verse, we would also ar­gue that UK small- and mid-caps can offer a dif­fer­en­ti­ated source of in­come.

We do not specif­i­cally tar­get high yield­ing shares, in­stead our focus has al­ways been on find­ing high-qual­ity, cash-gen­er­a­tive businesses that are run by ex­cep­tional man­age­ment teams, that are there­fore able to in­vest for con­tin­ued growth and in many cases de­liver a grow­ing div­i­dend to share­hold­ers over the long term. This is an out­put our in­vest­ing process, but one that has been very suc­cess­ful in en­abling the Trust to gen­er­ate not only strong cap­i­tal re­turns since in­cep­tion, but also in­crease our div­i­dend ev­ery year for the past 14 years2. It is this abil­ity to grow our div­i­dend that we feel has, and will be, a valu­able com­po­nent to fund­ing peo­ple’s re­tire­ment since it has the po­ten­tial not just to main­tain but grow dis­pos­able in­come.

The Black­rock Smaller Com­pa­nies Trust plc has a pro­gres­sive div­i­dend pol­icy, mean­ing that we are com­mit­ted to grow­ing the div­i­dend in each fi­nan­cial year. How­ever, at times of eco­nomic stress or re­ces­sion, some com­pa­nies may be un­able to grow their div­i­dends and in fact may have to sus­pend the div­i­dend. The closed-end struc­ture of the Black­rock Smaller Com­pa­nies Trust en­ables it to keep a pro­por­tion of the div­i­dend in­come re­ceived in a rev­enue re­serve, cur­rently the re­serve on the Trust is around 1.5 years. The ben­e­fit of hav­ing a rev­enue re­serve is that even in times when com­pa­nies may be hold­ing back on the cash that they re­turn to share­hold­ers, the Trust will be able to con­tinue with our pro­gres­sive div­i­dend pol­icy. To date, the Trust has not needed to use any rev­enue re­serves, and even in the fi­nan­cial cri­sis of 2008, the Trust was able to grow the div­i­dend through in­come gen­er­ated from our holdings.

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