Small companies are traditionally seen as the place to invest for capital growth: their cash flow is more often invested in expanding the business than in rewarding their shareholders.

But that is changing. A growing number of big companies have had to trim or dispense with dividends – such as the banks and BP – while a growing number of small and mid-sized companies are increasingly committed to generous, and growing, dividends.

Martin Brown, manager of Ignis UK Equity Income fund, points out that just 28 companies valued at £5 billion-plus have a yield above the 3 per cent market average, compared with 117 valued at between £200 million and £5 billion. What’s more, the average yield on the smaller stocks is marginally higher than on the large, at 4.5 per cent compared with 4.3 per cent.

Despite the attractions of smaller companies, most income funds still hoard the mega-caps: Brown estimates that the average income fund has almost 60 per cent of its assets invested in them. But there are more managers willing to turn to the mid caps and below in pursuit of income.

Brown’s fund is one: 60 per cent of its assets are in mid and small cap companies, compared with just 32 per cent for the average income fund. The heaviest weightings in his portfolio include Lloyds Banking Group, Vodafone, Cookson the materials services group, Aviva and BT. While Vodafone and BT are fairly well represented in the portfolios of other income funds, with an average of 5.2 per cent and 1.8 per cent respectively; the others account for less than 1 per cent of rivals’ portfolios. 

Brown has little exposure to other income managers’ favourites. He holds neither AstraZeneca nor BP, and has just a 2.6 per cent weighting in GlaxoSmithKline, compared with 5 per cent plus for his rivals.

Focusing on small companies has helped the fund’s performance. According to figures from Trustnet, it comes in 31st out of 99 over the past year, with a return of 18 per cent, ahead of UK equity income stalwarts such as Artemis Income and Newton Higher Income, although it’s more in the middle of the tables over the medium term.

‘We buy companies irrespective of their market capitalisation and, in general, find there are more opportunities for decent growth and dividends in the mid and small caps,’ says Brown.

Gervais Williams agrees. He recently left Gartmore after 17 years and is now managing director of MAM Funds, where he has launched the Diverse Income Trust, an investment trust targeting a yield of 4 per cent. In a difficult time for new launches, the trust raised £50 million, a testament to Williams’ record managing small companies funds: his Gartmore Growth Opportunities fund grew its net asset value by 65 per cent in the 10 years to the end of August 2010, when Williams stepped down, compared with a 6 per cent rise in peer group funds and a 13 per cent drop in the small companies index.

He thinks income is going to become more important for investors as capital growth becomes harder to achieve: ‘If you can [find companies] which can deliver a good yield and increasing income, that will justify stock market investment even if there is not much capital growth.’

While his fund will invest in behemoths, he is an enthusiast for small companies. He points out that, while the FTSE 100 index yields around 3 per cent, the FTSE Fledgling yields almost 4 per cent – and some shares as much as 8 per cent. He is also seeing signs that, as income becomes more highly valued by investors, small companies will respond by introducing dividends. Moreover, while mid-cap shares have been outperforming the tiddlers recently, he thinks that will change – and, over the long term, small companies have been the best performers.

Indeed many of this month’s award-winning investment trusts (see the supplement in the July issue of Money Observer) focus on small companies – including Herald, F&C Global Smaller Companies and Scottish Oriental Smaller Companies. Investors looking to diversify their income away from the FTSE 100 should give them serious consideration.