How Prudent It Is To Look Beyond Large Caps at London Stock Market For Your Income Portfolio?

  • Jul 26, 2019 BST
  • Team Kalkine
How Prudent It Is To Look Beyond Large Caps at London Stock Market For Your Income Portfolio?

Income portfolio strategy is a popular investment strategy used by investment professionals and individual investors alike. The strategy is a semi active one and aims at dividend earnings rather than capital gains as the main source of returns on their portfolio. The selection of stocks for this portfolio is, however, tricky and requires a study of a number of stocks, into extended periods into their history to see how consistent they are in distributing dividends, and how likely or unlikely they are to distribute a higher or lower rate of dividend In the coming period. Then there is also the question of risk return trade-off, with some believing that choosing a mid-cap or low-cap stock into this portfolio can provide better returns on account of higher dividend yields on these stocks.

First let us understand what the market capitalisation is, it is the value of a publicly traded company as determined by its investors, at any given point of time, in the stock exchange of its domicile. It is calculated as the total number of shares outstanding multiplied by the current price at which the shares of the company are trading at the bourses. Based on the total demand and supply forces in action, the companies listed on the bourses may be ranked from the most valuable company in the market to the company with the least market value. However, market capitalisation is a volatile element and keeps on changing with every trading at the stock exchanges.

Other than determining the value of a company, the term is also used to get several dimensional insights into the many facets of a stock; like trading patterns, speculative interest and information sensitivity. It says a lot about the stocks when looked at in comparison to the market capitalisation of other companies in the same market or the capitalisation of the stock market as a whole. One of the ways this instrument of measurement is used is to segment the stock market into different groups, based on their market values. Companies with the highest values may be called as large-cap stocks, companies with mid-range values may be called as mid-cap stocks and companies with less to least market capitalisation may be called as small-cap stocks. There is no set value in terms of units of currency as to what constitutes a large-cap, mid-cap or a small-cap company, and it differs in different markets based on a company’s individual value rankings in their respective markets where they trade.

Categorising the market into three segments based on the above logic of differentiation helps to understand the demand and supply forces at work at any point of time in the market. It reveals the behaviour of different categories of investors like mutual fund managers, high net-worth individuals and ordinary investors in terms of their preference in selection of stock and also how often they would trade in stocks of a particular category. The differentiation also helps in understanding investor movement patterns among these market segments during different periods of economic cycles.

Over the past several years, studies have been done by individuals, stock market researchers and academicians alike, to understand the different facets of insight thrown by this method of capital market observation. The evident objective of these research exercises undertaken is to determine which category will be a better value creator in different market circumstances. The differentiation method also helps to determine what strategies may be adopted by investors with different styles of investing and objectives they seek to accomplish.

Large-cap stocks are stocks with the most investor interest. These stocks usually command the highest proportion of the total market capitalisation in a stock exchange. These stocks are generally the most traded and are the most liquid of all stocks traded on a stock exchange. These companies do give good dividends, but at times it is seen that yields are unattractive on account of high prices of their stocks. Hence investor building a mid-to-high risk moderated portfolio invest in these stocks as this category of stocks are usually the safest, with least risk of capital loss compared to mid-can and low-cap stocks

On the market capitalisation value list, as you go down, the risk associated with each individual script keeps on increasing, along with their return profiles. Mid and small-cap stocks provide good investment prospects if the investor has a higher risk appetite.

Investing in mid-cap and small-cap companies, however, involves a great deal of research work along with smart portfolio construction and updating techniques to achieve the desired results.

When building a portfolio, an investor or a fund manager aims to moderate his risk by investing in a portfolio of stocks while targeting a return higher than that of the market portfolio (a portfolio will all the stocks in the stock exchange). One of such popular portfolio types is an income portfolio. In which, the emphasis is more on higher yield in dividend income than what the market portfolio generates. Such portfolios usually are less inclined towards investing for capital gains. They do minimal portfolio churning and try to save as much as they can on transaction costs. However, building and updating this portfolio is not an easy task. There are three key objectives a fund manager would try to accomplish in building and updating this portfolio to maximise his returns. First, he keeps the number of transactions to the minimum to keep his cost of operations low, Second, he would have a list of stocks with highest to lowest dividend yields to invest in and invest in the list where his risk profile fits the best. Third, he will use every market given opportunity to move up the ladder on that list, so that the return potential of his portfolio may increase for his given level of risk. In theory, this is a semi-active technique, but difficult to implement in the event of uncertainty in earnings of a mid to low cap stock in the portfolio.

The risk involved with this portfolio is two-pronged, first the earnings of companies are highly correlated to the general economic environments of the countries or geographies they operate in, hence in times of recession this portfolio may not provide any returns at all, however on the bright side there is less chance of a capital loss as these companies are usually well established. The other risk factor is stock-specific, high dividend-yielding stocks are usually growth stocks or stocks with windfall gains, growth stocks need money to continue investing in themselves and companies with windfall gains will not be able to repeat their performance. Such stocks are not consistent in distribution of income, and a manager may have to wait till the date of announcement from company management to know that that the stock in his portfolio is not going to earn him anything, and this risk is different from the general risk profile of a company. It is very difficult to mitigate this risk if not impossible on part of an investor or fund manager.

There are more dividend-paying stocks to be found in the mid-cap category than with the low cap end of the market. Low cap stocks are usually cash strapped with a high-risk, high return profile and are ill-suited for an income portfolio. The key however of finding a good income stock in the mid to small-cap category that would sit well in an income portfolio is to look for two important factors; first, the company has consistent earnings and second that it is cash-rich. Only these companies are in a position to distribute cash to its investors, a number of companies in the mid-cap segment may be found that are not investing in growth and would rather distribute their earnings to the shareholders. Examples of such type of companies are old well-established businesses, having a niche in the market with a limited to nil competition and a product portfolio that is static, like in a public sector utility company.

An Income portfolio to be built which targets, mid-cap to small-cap stocks in it will have to look into all the above aspects while simultaneously keeping track of the risk profile of their portfolios with ever-changing market dynamics. It is a myth if at all it is suggested that adding mid-cap or small-cap stocks in an income portfolio will bring in greater returns at the cost of a slight but manageable increase in the portfolio’s systematic risk. As discussed earlier, it is difficult to comprehend the total risk involved in building an income portfolio with the additional component of uncertainty in the actual materialisation of dividend income while the general risk profile of the stocks remaining the same. In fact, a strategy that focuses more on fundamental aspects of individual stock with good dividend yields will provide greater caution against any risk posed to such a portfolio. The strategy of buying the target scripts at dips and selling at ups to add quantity to bring down the average cost of holding has a better chance of achieving a higher yield target, albeit at higher costs.

There is an additional problem which often gets overlooked by investors and fund managers alike when they want to make money from an income portfolio. These days companies are choosing the route of share buy-backs to distribute cash to investors. This puts the whole concept of Income portfolio investing in utter disarray. A Large market capitalisation company is more likely to use this method than a mid-market capitalisation company. This adds another risk element to the risk-return dimensions associated with income investing. In conclusion, there is so much more to look out for in building an income portfolio, than building a general portfolio with both income and capital gains components that it may not be worth the effort. Given the additional risk elements discussed income portfolio investing objectives are difficult to achieve.

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

Amidst this, are you getting worried about these falling interest rates and wondering where to put your money?

Well! Team Kalkine has a solution for you. You still can earn a relatively stable income by putting money in the dividend-paying stocks.

We think it is the perfect time when you should start accumulating selective dividend stocks to beat the low-interest rates, while we provide a tailored offering in view of valuable stock opportunities and any dividend cut backs to be considered amid scenarios including a prolonged market meltdown.

To know more about these dividend stocks, click here

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