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Searching for Income

John Baron makes changes to the Income portfolio at a time when higher-yielding trust discounts have all but disappeared
March 6, 2014

Being a ‘live’ portfolio, it is very transparent that the Income portfolio’s steadily rising income stream has over the years significantly contributed to its solid performance against its respective WMA (formerly APCIMS) benchmark. Given the low level of interest rates, ‘income’ investment trusts continue to be popular. But there are still pockets of value to be found in those trusts with decent revenue reserves provided one is prepared to take a contrarian view of certain sectors.

The importance of dividends

Regular readers will know that I tend to stay invested and do not second-guess short term market movements. Wiser investors than I profit from such activity. One advantage of sticking with the market is that it allows full access to dividends. For over the long term, evidence suggests it is dividends which account for the majority of the market’s total returns.

Readers may then wonder why there is any need for a ‘capital growth’ strategy. I suggest that, whilst recognising the importance of dividends, it is also important to remember that such a growth strategy allows greater freedom to search for better opportunities – and works well if you get it right!

For example, readers will be aware of my long held enthusiasm for the smaller company, biotech and technology sectors. These companies do not typically yield much, but they have contributed to the Growth portfolio’s outperformance of both its benchmark and the Income portfolio over the years. Of course, simply tracking or underperforming the indices is another matter.

However, as a general rule, finding and re-investing dividends is key to healthy returns. The latest annual Barclays Equity Gilt Study illustrates the point. Had £100 invested in UK stocks at the beginning of 1900 tracked the market, it would have been worth £191 today in real terms (after inflation) if dividends had not been reinvested. But if dividends had been reinvested, the figure shoots up to £28,386. The respective figures using 1945 as the starting point are £271 and £5,140.

Such a message is not confined to UK markets. Legendary investor Jeremy Siegel, in his book ‘The Future for Investors’ (2005), calculated that as much as 97 per cent of the total return from US shares came from reinvested dividends. $1,000 invested in 1871 would have been worth $243,386 by 2003. But this figure rises to $7,947,930 had dividends been reinvested.

I will not be taking such a long term view. But the message is clear: if you want to succeed over the long term then do not spend your dividends – reinvest them instead. And the good news is that, in contrast to both governments and consumers, corporate balance sheets are healthy and therefore paying out good dividends.

Qualifications

In searching for income, there are one or two factors worth noting. First, I do not chase an unsustainable yield. A 5 per cent yield looks attractive, but less so if the dividend is not increased over time or, indeed, cut. In contrast, a 4 per cent yield growing at 8½ per cent a year will be worth over 6 per cent after five years. So I try to ensure that my income investment trusts have sufficient revenue reserves to sustain dividend increases through stormy weather. This important principle is one which has helped to guide the changes to my Income portfolio during February.

Furthermore, one should also recognise that many overseas markets not only offer decent yields, but also fast growing ones.

When speaking at the Investors Chronicle ‘Investment Trusts for Income’ seminar last spring, I remember highlighting how the geographic ‘ownership’ of global equities yielding over 3 per cent had changed over the last 15 years: the noticeable movements were the UK’s share falling from 20 per cent to 7 per cent, whilst Asia’s had risen from 16 per cent to 30 per cent. Indeed, more than one-third of all global equities yielding 4 per cent or more could be found in Asia.

In addition, these same companies have been producing very healthy dividend increases over the years – a trend confined not just to Asia. Emerging markets enjoyed particularly good dividend growth relative to other markets over the period 2009-2011. Healthy dividend increases can be deceptively beneficial to income portfolios.

Finally, at times when most income investment trusts are popular and therefore discounts are hard to find, I try to focus on sectors which are out of favour. This is a perfectly valid tactic. In a perfect world, one would be buying trusts on an above-average discount in the hope that both a sector rerating and discount tightening would produce a ‘double whammy’. But when those discounts do not exist, one must focus primarily on the sector fundamentals.

During the autumn of last year (August–November), I wrote a series of monthly columns making the case for a number of unloved sectors – those being technology, commercial property, emerging markets and commodities. Space here does not allow a summary of the arguments, but I have returned to two of these sectors when searching for yield in the Income portfolio.

Portfolio changes

After a strong run, and with the discount having disappeared, I sold the Income portfolio’s holding of Schroder UK Mid Cap Fund (SCP). It is an excellent trust and one which remains in the Growth portfolio.

With the proceeds, I have added to JPMorgan Mid Cap Investment Trust (JMF) when standing on a near 10 per cent discount. It also offers a slightly higher yield. Like SCP, JMF has been an excellent performer in a sector which should continue to produce good dividend growth. My only quibble is that this year’s near 6 per cent increase came in the form of a ‘special’ (ie possibly non-recurring) dividend, which risks sending the wrong message.

I also topped up my holding of Henderson Far East Income (HFEL). A series of healthy annual dividend increases averaging nearly 8½ per cent over the last four years, a starting yield when bought of 6 per cent, and a decent exposure to out-of-favour China (in a region generally which has been de-rated considerably), all encouraged my enthusiasm for the stock.

Finally, I have added once again to Standard Life Investments Property Income Trust (SLI). In a sector which was deeply unpopular not so long ago, SLI has been one of the best at growing its NAV. Sentiment is now changing. Meanwhile, the present yield of 6.2 per cent is supported by strong revenue reserves and a penchant for industrial properties outside the South-East yielding in excess of 8 per cent. Despite its premium to NAV, I believe the sector still has a long way to go as investors continue their search for reliable income.

Otherwise, there were no changes to the Growth portfolio during February.

View John Baron's updated Investment Trust Portfolio.

John's book is out now. It explores the merits of investment trusts, the stepping stones to successful investing, and how to run and monitor a trust portfolio. Available from Amazon and other bookshops