UK Smaller Companies – an alternative to the income dilemma?

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.