Small cap stocks should not be ignored by income investors, according to Simon Moon, co-manager of the Unicorn UK Income fund. 
A hefty 86 per cent of all UK dividends paid out in 2015 were by stocks in the FTSE 100, according to data from Capita, with 33 per cent coming from the top five (Shell, HSBC, BP, GlaxoSmithKline and Vodafone).
However, many fear due to poor earnings growth, macroeconomic headwinds and threats to business models, many of these FTSE 100 companies will not be able to continue to pay their current dividends, with the likes of BP and Vodafone now with only 0.5 times dividend cover.
As the below graph shows, FTSE 100 companies have been on the rise since Brexit, despite an immediate drop, as many investors have been forced out of safer holdings such as government bonds and have preferred multinationals that have benefitted from sterling weakness.
Performance of indices in 2016
Source: FE Analytics
While sterling has fallen, giving companies reporting in US dollars a relatively healthier balance sheet, concerns remain that despite this one-off boost, firms are not earning enough to cover their dividends over the long term.
As a result, Simon Moon, who runs the Unicorn UK Income fund with FE Alpha Manager Fraser Mackersie (both pictured), suggests investors look to small caps to add income.
“That’s really the attraction to small and mid-caps - that they’re able to provide sustained dividend income and earnings per share growth,” he said.
Despite this, he notes it is key for investors to diversify.
In his £688m income fund, Moon has just 5.7 per cent in FTSE 100 companies, with 44.3 per cent in mid-caps and 22 per cent in small caps.
He says that having a buffer of highly liquid FTSE 100 stocks alleviates some of the risk of owning more illiquid smaller companies.
Since Moon and Mackersie became lead co-managers in 2014 the fund has struggled, with smaller companies enduring a difficult 2014 and 2016.
Performance of fund during manager tenure
Source: FE Analytics
Last year, however, the pair righted the ship and the fund was among the top performers in the sector.
With this year being particularly difficult to predict, the fund, which yields 4.3 per cent and has an ongoing charges figure of 0.81 per cent, is again the bottom quartile, but Moon is confident that by focusing on small caps he is adding opportunities that others will miss.
“There’s not enough downside risk to warrant the level of discount you are currently seeing against the FTSE 100,” he said, adding that there are a number of opportunities within the small and mid-cap space, two of which he highlights below.
BBA Aviation
The company provides on-airport services and support with refuelling and maintenance work to aircrafts and last year it bought out competitor Landmark Aviation.
“What they do is they own and run fixed base of operations so if you are flying a business or a private jet in North America you will likely land in one of BBA’s [airports] to service and refuel” Moon said.
Before the deal, the company was already the largest in its area and Moon sees the firm going from strength-to-strength even if the market has some questions marks.
“There’s cost synergies in that acquisition but there’s also revenue synergies as well,” he said, referencing the company’s new potential pricing power.
Performance of stock over 2016
Source: FE Analytics
He says the market was “spooked” by the level of risk taken on by the acquisition and level of debt within the company.
“They have successfully managed to pay down debt at a very fast rate,” Moon said.
“They have a division ready for sale which means it should be sold in the next 12 months – if they sell them they can pay down debt faster still, further reducing leverage.”
To this end, last week the firm announced the sale of refueller ASIG to John Menzies for $202m, with $160m in net proceeds.
If this continues, Moon says “that means they can materially increase what is already a high dividend payment because they’re so cash generative.
FDM Group
In contrast to BBA, graduate trainee outsource provider FDM Group has performed very well in recent years.
As the below graph shows, the company has more than doubled in value since it went public in July 2014, returning 113.88 per cent to investors over the period.
Performance of stock since IPO
Source: FE Analytics
“Say one of their tech clients want 20 graduates trained in September, FDM source them, trains them in its own academies and places them for two years so you get to ‘try before you buy’,” Moon said.
“Some did think that after Brexit, as this is an international business that plays off the UK academic reputation, it would lose sales in America and across the rest of the world,” he added.
During this time, the fund topped up at a price significantly less than the company’s £6.35 valuation currently.
“You’ve had a bit of a V-shaped recovery in terms of price there and that indicates the level of opportunities there were in some of these companies just after the Brexit vote. And with high levels of volatility we expect to see a few more as well,” Moon said.