Small-cap stocks could soon outshine the FTSE 100 for income potential, according to the October Dividend Barometer report from Octopus Investments.
The report reveals that smaller and mid-cap companies are forecast to offer higher dividend yields and better dividend cover than their larger counterparts by 2025. This marks a significant shift for income investors traditionally focused on the FTSE 100.
The research projects that by next year, the FTSE Small Cap index will yield 4.33%, surpassing both the FTSE 100’s expected 3.97% and the FTSE 250’s 3.88%.
This outlook makes a strong case for considering smaller companies in dividend-focused portfolios.
Once-in-a-cycle opportunity
Chris McVey, Deputy Head of Octopus Quoted Companies, commented: “A once-in-a-cycle opportunity to consider allocating to UK growth equities currently exists. While the recovery is in its infancy, the opportunity for investors is ripe.”
His comments underline the potential of these companies, which is often overlooked in favour of the larger names within the FTSE 100.
Smaller companies listed on the FTSE AIM index, for instance, have seen total cash dividends grow by an impressive 68.4% over the past decade, compared with a 17.33% increase among blue-chip companies over the same period.
McVey added: “Looking beyond the largest UK equity dividend stalwarts highlights smaller growth companies that have the potential to generate significant capital growth, with attractive track records of paying consistent and growing dividends.”
Cover is the key to sustainability
The Dividend Barometer also highlights dividend cover, a measure of how sustainable a company’s dividend payments are.
While Footsie's dividend cover is expected to reach 2.3 times earnings by 2025, smaller companies offer even greater security.
The FTSE Small Cap’s cover is forecast at 2.44 times earnings, while the AIM index is set to lead with a cover of 3.6 times.
This suggests that smaller companies not only provide higher yields but are also more likely to maintain or grow their dividend payouts in the long term.
McVey explained: “Dividend cover is higher for smaller companies, giving investors increased confidence that these businesses can maintain or grow dividends. This is a compelling advantage for income-focused investors looking for long-term stability.”
The report also draws attention to diversification, pointing out that the FTSE 100 is highly concentrated, with the top 10 companies accounting for 56% of its total dividend payouts.
Broader base
In contrast, the top 10 companies in the FTSE AIM index contribute only 37%, while the FTSE 250’s top 10 make up just 22%.
This wider base of dividend payers among smaller companies helps to reduce the risks associated with relying on a handful of large firms for income. “Equity income investors will benefit from materially better levels of diversification by looking beyond the FTSE 100,” McVey stated.
In addition to offering better yields and diversification, smaller UK companies are currently trading at a discount compared with their US peers.
The Dividend Barometer shows that the FTSE AIM and the Deutsche Numis UK Smaller Companies Index are expected to deliver earnings growth on par with the Nasdaq Composite by 2025, yet at much lower price-to-earnings multiples.
For example, the FTSE AIM trades at around 13 times earnings, whereas the Nasdaq commands nearly 24 times earnings.
M&A opportunity
The report also highlights a wave of mergers and acquisitions (M&A), as investors take advantage of the low valuations of UK growth stocks.
The average bid premium for UK companies valued at over £100 million was 45% between July 2023 and July 2024.
McVey remarked on this trend: “The significant discount UK growth equity markets are trading at, compared to their true underlying value, is attracting substantial interest from investors globally.”
Taken together, these factors suggest that smaller and mid-cap companies could offer not only higher dividend income potential but also stronger growth prospects and lower valuation risks compared with larger FTSE 100 firms.
Investors who are willing to expand their portfolios beyond the traditional blue-chip stocks may find this a unique opportunity.
As McVey concluded: “The current landscape presents a clear case for investors to broaden their approach and consider a multi-cap strategy for income generation and growth.”
For income-focused investors, the message from Octopus is clear: smaller companies could hold the key to unlocking better dividend returns and portfolio diversification.