Here's some of the best income opportunities in small- and medium-sized stocks

Cast your nets further down the market cap spectrum, say James Henderson and Laura Foll of Lowland Investment Company.

The UK dividend seeker’s dilemma: avoiding too much income concentration.

The concept surrounds a fairly well-penned story in the press about how the vast majority of the UK’s dividends are paid by a small cadre of the top FTSE 100 companies: the top 20 companies hand-out 70 per cent of all UK dividends paid; the top 10 pay 50 per cent; the top five pay 35 per cent. 

But what choice do we have? This is the structural nature of the UK’s stock market. 

Actually, there is choice, and it’s a great argument for the professional oversight of good active fund managers. We are not forced to overly concentrate our portfolios in pre-determined amounts according to index weightings; we are free to balance perceived risks and extract income from a variety of sources as we see fit.  

The small and mid-cap space is usually reserved for the growth investor – those seeking above-average levels of earnings growth, which they believe will translate into strong share price returns. Large caps have tended to be more associated with income seekers.

-Share Watch: Four small cap shares that should be on your radar

The income rationale behind larger businesses is that strong and stable companies with entrenched market positions and experienced management tend to be very focused on creating shareholder value and therefore delivering steady or rising levels of dividends.

But there are plenty of businesses further down the size scale that engender these qualities. In fact, in the Lowland portfolio they are some of its highest-yielding stocks. 

Looking at the broader evidence, the FTSE 250 – the UK’s mid-cap market – is forecast to pay a 3.0 per cent yield this year; the FTSE Small Cap is forecast to pay 3.1 per cent. This compares to the higher-yielding FTSE 100, which, although it yields a higher 4.2 per cent, has a lower level of dividend cover.

Because of their lack of liquidity, mid and small cap stocks are often under-researched by analysts. Less coverage means less information feeding into the stock market and the share price, giving the savvy investor a greater chance of uncovering undervalued stocks with attractive yields.

Below are some examples of high-yielding stocks from lower down the market-cap scale, where small-cap is defined as a company worth less than £500 million. 

Motoring ahead – Redde

When your car breaks down or you’re involved in an accident, a few things are crucial in rectifying your situation: you need to get the car fixed and pay any legal or medical expenses that may need covering. You also need a replacement car for the interim. Redde assists the insurers with some of these jobs – running fleets of courtesy cars and operating repair garages.

The business – around £450 million in size – is proving to be a success: increasing market share, which in turn is resulting in strong earnings growth and dividend growth. Currently it’s yielding 6.6 per cent.

Suited to all occasions - Moss Bros

Moss Bros leads the pack in the UK for branded suits. Its journey since the financial crisis has been one of improvement and change. Years of underperformance made way for new management and a shake-up of the product range, disposals of non-core assets, and store refurbishments. The changing nature of the competition also helped – the quality of suits in rivals M&S and Next has slipped. 

All-in-all it is a niche and profitable business with above-average retail sales growth relative to its marketplace and a healthy dividend payout, which is propped up by a strong net cash balance sheet in the event of a downturn. It’s worth about £100 million and currently yields 6.1 per cent.

A market for convenience – McColls

Head down to your local shops and you might notice a McColls convenience store or newsagents. They’re a growing presence, at around 1,400 stores. Convenience stores are one of the higher-growth areas of the food market with fewer cost pressures than their supermarket cousins. 

Recently, management have wrapped up a very good deal for the business – buying 298 stores from Co-op, enabling them to exert much greater buyer power and cost savings on the goods purchased for their stores. The product range has also improved over the past five years and they’ve been gradually switching the mix from lower margin tobacco-driven newsagents to higher-margin convenience stores with fresh produce. 

The business is valued at around £90 million. Its current yield is 5.1 per cent.  The concentration of income in the UK equity market has led us to seek out lesser-known sources of dividends to diversify the portfolio’s revenues. Exemplified in some of its holdings, attractive yields can be found where many an income manager would not look – in small and medium sized businesses. This may give the UK income-seeking investor the chance to depart from the status quo of large-cap driven dividends. 

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