The pandemic had a significant impact on the UK income space, with many companies forced to slash and cancel dividends to ensure they survived the crisis. It was the traditional large dividend paying sectors and companies that suffered some of the biggest cuts, with many larger companies using the crisis as an opportunity to reset  excessive payouts at more sustainable levels.

This means income managers are looking outside of their ‘usual suspects’ for dividend income and should mean small and mid cap income stocks will be highly prized.

These under the radar dividend payers could also be a good hunting ground for individual investors and we have run a screen targeting this part of the market. From the resulting list we have identified two smaller company income plays to buy.

SMALL CAP INCOME ‘UNDERAPPRECIATED’

Gervais Williams and Martin Turner manage The Diverse Income Trust (DIVI), a multi-cap portfolio able to select ‘the best stocks from an income and income growth perspective from across the UK market’.

They say the small cap income universe is ‘absolutely’ still underappreciated by investors. ‘The merits of smaller companies remain overlooked. This is reflected in low company valuations relative to prospects where Brexit has had a lagged impact.

‘We see this changing, helped by the resilience of many of the companies through Covid and renewed interest in the UK prompted vaccine progress. Collectively, smaller companies also remain overlooked for the stock and sector diversification benefits they bring a portfolio, avoiding income concentration and associated risk common in mainstream indices.’

‘Our process considers the prospects for underlying growth in revenue and cash flows and where the market has undervalued this potential. We look for strong balance sheets that provide optionality for growth and can withstand economic shocks.’

Also scouting for income further down the cap scale are Fraser Mackersie and Simon Moon, co-managers of the Unicorn UK Income (B9XQFY6) and Unicorn UK Ethical Income (BYQCS25) funds. Mackersie looks for ‘profitability, cash generation, low levels of debt’ and likes companies that are ‘in a very strong market position. They will be the biggest and the best in their space, even if it is might be quite an obscure, niche market’.

Unicorn UK Income’s holdings range from larger companies such as retailer B&M (BME), savings and retirement group Phoenix Holdings (PHNX) and property play LondonMetric (LMP) to much smaller dividend paying companies such as construction industry equipment maker Somero (SOM:AIM)), gifting and reward products company Appreciate (APP:AIM) and legal services consolidator Gateley (GTLY:AIM).

‘MISPRICED OPPORTUNITIES’

Mackersie insists the attractions of fishing for income in the small cap pond include the fact that ‘analysts’ coverage is lighter, so there are more mispriced opportunities. And from an income perspective, we think the quality of income is very good further down the market cap scale as well,’ he adds.

‘You see high levels of cover and very good long-term dividend track records.’

Brendan Gulston, co-manager of the LF Gresham House UK Multi Cap Income Fund (BYXVGS7), anticipates ‘a meaningful dividend recovery across the market, particularly for those with the flexibility to look across the market cap spectrum.

‘Among small and mid-cap companies, there are areas of the market that have strong visibility of earnings, which can underpin robust and resilient dividends.’

He looks for a combination of ‘long-term sustainable income streams and structural capital growth opportunities across the market cap spectrum.

‘We implement disciplined risk mitigation processes and use qualitative and quantitative criteria to appraise companies, as well as leverage our proprietary network of independent experts to drive conviction in investment opportunities,’ he says.

PUTTING IT INTO PRACTICE

To help discover some lesser-known dividend payers for itself, Shares screened the market for stocks with a market value of £300 million or less, a forecast dividend yield of 3% or more and dividend cover (the ratio of earnings per share to dividend per share) of at least 1.5.

As a rule of thumb dividends should be covered at the very least 1.5 times by earnings if they are to be sustainable. While dividend growth figures are affected by the pandemic – with many payouts suspended in 2020 – we also stripped out firms which are forecast to cut their dividend.

We ignored stocks with double-digit forecast yields on the basis the market is either telling you the dividend is under threat, or the numbers are wrong. The resulting table has an interesting mix of companies from a variety of different sectors, from mining to cosmetics, legal services and car retailing.

The most generous yield on offer is from Raven Property (RAV) at 8.6%. The shares have been weak for a while and that could have pushed up the yield.

Raven invests in logistics assets, which have been boosted by the acceleration of the growth in online shopping during the pandemic, but also derives its rent in rubles and reports in sterling. This makes its results highly sensitive to a Russian economy and exchange rate which, in turn, is affected by movements in the oil price and economic sanctions imposed on Russia by the West.

This demonstrates that you need to look underneath the numbers themselves to get a fuller picture of the risks facing the company and the income stream. This is arguably even more important with less mature businesses which can be more prone to volatile trading.

SMALL CAP INCOME PICKS

Alumasc (ALU) 218.6p

Dividend yield: 4%

Despite a strong rally for the shares, recently boosted dividend expectations at building materials firm Alumasc (ALU) mean it continues to offer an attractive looking yield of 4% based on consensus forecasts. As broker FinnCap observed at the time of the company’s first half results (4 Feb) the business is enjoying ‘good sales momentum, improving quality of earnings, stronger balance sheet and longer visibility of forecasts’. Formerly a conglomerate of engineering businesses, the company has narrowed its focus in recent years to focus on niche construction-related products including sustainable products which help conserve energy and water and solutions which help constructors meet building regulations. The company is also investing in innovation to broaden its product range. One of the growth opportunities for the group is to expand its export business which currently accounts for 13% of overall revenue.

Carr’s (CARR) 155p

Dividend yield: 3.3%

Having demonstrated resilience during Brexit uncertainty and the pandemic, a first half profit uplift leaves Carr’s (CARR) on course for a return to full year growth. This time last year, the company deferred the payment of an interim dividend until the full effects of the pandemic were clearer, then paid a flat dividend for the full year. In a sign of new CEO Hugh Pelham’s confidence, Carr’s recently declared an initial interim dividend of 1.175p for the year to August 2021 (it typically pays two interim dividends). A continued positive performance across the agricultural divisions is forecast and Pelham sees an improved second half to come from the engineering division as Covid recedes and the order book strengthens. For the year to August 2021, Investec forecasts a dividend increase from 4.8p to 5p, a payment covered almost 2.5 times by estimated earnings of 12.3p, with the distribution predicted to rise to 5.2p and 5.5p in 2022 and 2023.

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