There are often trade-offs inherent in stock market investing: long-term growth versus short-term volatility, for example. This can apply to income as well: investors looking for long-term, reliable income from a stock market portfolio may have to sacrifice some capital growth. However, the environment today requires no such trade-offs: there is more growth in traditional income areas, and also more income in traditional growth areas.

In the UK market, dividends have traditionally come from the largest companies. The FTSE 100 remains a reliable source of dividends, with a yield of around 3.7%. In 2023, UK companies paid £90.6bn in dividends, with 85% coming from 15 companies. Dividends from the UK largest companies are projected to show slow but steady growth over 2024.

The problem for these larger, dividend paying companies is that their growth prospects haven’t been exciting. However, today we see greater growth potential in this part of the market. After a period of weakness, the UK market remains very cheap. It trades on a 40% discount to global markets. While some of that is its sector composition, UK companies are still notably cheaper than their global equivalents.

Reappraising the UK

There are signs that investors are starting to reappraise UK larger companies, with the FTSE 100 hitting new highs in May, and even outpacing the S&P 500 in the very short-term. This has had several triggers: BHP’s bid for Anglo American is a sign that M&A activity is heating up. It comes on the back of high-profile bids for Direct Line and Currys. It shows that corporate buyers believe there is value in the market.

There have also been significant buybacks, which has supported valuations. Barclays, for example, announced a £10bn buyback programme in February, around 40% of its market capitalisation. BP, Shell and HSBC are among many other major UK companies buying back their own shares. This has boosted share prices and helped galvanise the UK market.

There are also specific opportunities. Financials and commodities, both heavily represented in UK large caps, are beneficiaries of a ‘higher for longer’ interest rate environment. We have a higher weighting in banks in Shires Income. They are generating cash and returning that cash to shareholders through dividends and buybacks. They are also on low valuations relative to their history and the wider market.

The utilities sector is also a source of income and potential capital growth. The energy transition is creating growth opportunities for individual companies. The electricity grid, for example, needs significant investment to support electrification. We hold National Grid & SSE in the UK and several European energy companies.

Growth prospects for small and mid-caps

If there is more growth in the income part of the market, there is also more income in the growth part of the market. Historically, small, and mid-caps have been a source of dividend and capital growth, but dividends payouts have been lower in absolute terms. The yield on the FTSE 250 is currently 3.4%, which is as close to the FTSE 100 as it’s ever been. At 3.9%, the yield on the FTSE Small Cap is higher than that of the FTSE 100.

The growth prospects for small and mid-sized companies are still intact. After a period when this part of the market has been substantially out of favour, share prices are on multi-year lows. They have yet to experience the bounce-back seen among larger companies, despite smaller companies experiencing many of the factors that have driven larger companies higher – buybacks, and merger and acquisition activity, for example.

There are good opportunities in this part of the market. Over the long term, smaller companies tend to grow faster than larger companies. A shift in interest rate direction may prove the catalyst for this part of the market. Smaller companies tend to perform better after the first interest rate cut. The markets currently expect the Bank of England to cut rates before the end of the year. Against this backdrop, it appears a compelling moment to be taking on more exposure to small and mid-cap stocks. In Shires Income, we are already strongly overweight here.

In spite of this broad opportunity set, we have seen the discount on Shires Income widen out. Income-focused investment trusts have struggled to compete with the higher rates available on cash savings. However, with opportunities emerging from all parts of the stock market, a higher yield than most savings accounts, and the potential for growth in both income and capital, we would argue that the trust may be a better option to grow wealth over the longer-term.

Cash savings remain at risk from falling interest rates and inflation.

Investors may have had to weigh capital growth and reliable income in the past, but the market environment today requires no such trade-off. The weakness in the UK market has left traditional income stocks with growth potential, and traditional growth stocks with income potential. It is a market full of opportunities.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

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Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.

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