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Why you should be looking at small- and mid-caps to stuff into your income portfolio

Most income investors fill their boots with FTSE 100 giants such as BT and Vodafone, but with several high-profile dividend cuts of late, Octopus fund manager Chris McVey reckons a ‘multi-cap’ approach is needed

FTSE 100 dividends aren't as reliable as they once were; look at Vodafone, M&S and now Centrica

With British Gas owner Centrica Plc (LON:CNA) the latest FTSE 100 giant to cut its divi, one fund manager has warned income investors they need to start looking outside the usual bubble of big-name dividend payers.

Those seeking a reliable income from stocks – as opposed to capital growth – have traditionally tended to pour their money into a handful of ‘safe’ blue-chip stocks.

READ: FTSE 100 dividends set for new record in 2019 despite cuts from M&S and Vodafone

Nearly every income portfolio, for example, will hold shares in Royal Dutch Shell PLC (LON:RDSB), BP PLC (LON:BP.) or Vodafone PLC (LON:VOD).

In fact, just ten companies make up over 50% of total FTSE 100 dividend payments.                                  

“[As a result,] a large proportion of traditional income funds hold these ten stocks, leading to significant holding concentration,” explains Chris McVey, who oversees Octopus Investments’ UK Multi Cap Income Fund.

That’s fine when things are going well, but with Vodafone and Marks and Spencer Group PLC (LON:MKS) and Centrica recently slashing their pay-outs and BT Group PLC (LON:BT.A) mulling a cut of its own, the pool for these blue-chip-focused funds to pick from is getting smaller.

Read: High FTSE yields point to 'dividend slaves' that may cut payouts

Even those that have left their divis untouched are struggling with limited dividend cover – the extent to which distributions are covered by retained earnings (dividend per share divided by earnings per share) – as well as “often lacklustre profit growth expectations”.

On top of that, Link Group’s latest UK Dividend Monitor report showed that FTSE 100 pay-outs are becoming increasingly volatile.

Payments from the blue-chips hit a record high in the second quarter, according to the report, although this was flattered by a weak pound and hefty specials. The underlying performance was much more “disappointing”.

Still, with interest rates stubbornly low, income funds, with their better rates of return, remain popular with investors, who often use them to supplement their pensions.

Look at smaller dividend payers

But rather than focus solely on the big companies, McVey believes investors need to diversify and seek out funds that look at small- and mid-caps as well, where decent returns can still be found.

“A ‘multi-cap’ approach enables investors to benefit from the significant number of companies capable of generating superior profit growth and attractive income, particularly further down the market cap spectrum.

“Within mid-cap and small-cap companies, gems continue to be found. Small and mid-size companies consistently outperform their larger peers, while demonstrating this faster growth in earnings and dividends.”

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