Generating a decent retirement income is becoming increasingly challenging for today's retirees. Traditional sources of income, such as bank deposits, government bonds and annuities, offer much lower rates than they used to, while low growth and low inflation are holding back how much investments yield.
It's a problem that David Smith, manager of Henderson High Income Trust (HHI), is acutely aware of. "We've seen some high-profile dividend cuts so far this year: Rio Tinto (RIO), BHP Billiton (BLT), Barclays (BARC) and Rolls-Royce (RR) - to name a few," he says. "We had, I think, seven dividend cuts in the FTSE 100 last year, so it's becoming quite a difficult environment for income managers."
And yet, so far, Mr Smith has managed to navigate these choppy waters, delivering a 10-year annualised return of 6.7 per cent for the trust's investors. The trust yields 5.1 per cent and has increased its dividend payout for the past five years.
This performance is significantly better than many other asset classes, so how exactly has Mr Smith been able to generate income in such testing times?
"To get your total return, I think you really need to pick those stocks that can grow their earnings whether that's through self help or structural growth drivers," he says. "We are bottom-up stockpickers with a key focus on good quality companies, strong balance sheets and good free cash flow because it's really important that the companies we own do pay their dividends."
Despite recent dividend cuts by FTSE 100 companies Mr Smith says he does not expect further cuts to threaten the trust's revenue this year.
"One of the advantages of being a relatively small trust is that I have the ability to move up and down the market cap scale," he says. "So where we do have issues, maybe with high payout rates within the FTSE 100, I can be underweight this index and own more companies in the FTSE 250 and small-cap indices.
He also argues that mega-cap companies in the FTSE 100 are skewing the dividend payout ratio of UK companies, making it seem as though overdistribution is affecting the whole market. "Even though on an aggregate level UK companies look as though they're overdistributing, once you exclude the top 15 companies the market as a whole is fine," he explains.
The outlook for dividend growth, however, is a different matter. Analysts are forecasting weak dividend growth of between 0.5 per cent and 1 per cent this year, which Mr Smith agrees is not much at all. But despite this he believes it is still possible to find opportunities in companies that will grow their dividends with careful stock picking. He expects to receive good dividend growth from three different categories of companies.
The first of these he describes as quality cyclicals, companies that are able to grow their dividends quite aggressively as they are at the right point of the economic cycle. He cites ITV (ITV) and Galliford Try (GFRD) as two companies that are set for dividend growth rates of 25 and 22 per cent, respectively.
He is also looking to what he calls "stable growers": companies that have resilient business models and the ability to grow their dividend - irrespective of the economic outlook. Relx (REN:AEX) and Cranswick (CWK), which has grown its dividend for 26 years in a row, are examples.
The third type of company he is expecting good performance from are the "cash cows", which can be relied on to pay a dividend, have a high yield, and where he feels comfortable with the balance sheet and cash generation. He lists AstraZeneca (AZN) and Imperial Brands (IMB) - formerly called Imperial Tobacco Group - as two such companies.
He's also been adding Diageo (DGE), Victrex (VCT), Big Yellow Group (BYG) and Greene King (GNK) to his portfolio.
Pearson (PSON) was one of the main drags on the trust last year, but Mr Smith continues to hold the shares as he thinks the company represents a good recovery opportunity. "It has bounced off its lows, but has much further to go," he says.
"It has announced a new strategy for how it is going to turn around the business and has a longer-term target of £800m earnings before interest and tax (EBIT) over the next two years. Having met the company on several occasions and gone through how it gets to £800m, I'm pretty confident it can get there."
| David Smith CV David Smith is manager of Henderson High Income Trust and co-fund manager of a number of UK equity institutional funds as part of Henderson's global equity income team. Mr Smith joined Henderson in 2002 and initially worked in operations, after which he became a trainee fund manager in the UK equities team with sector responsibilities for media, travel and leisure, and housebuilders. When he became a CFA charter holder in 2008 he was promoted to fund manager. Mr Smith has a degree in Chemistry from Bristol University. |
Henderson High Income Trust can invest in bonds as well as equities. The split is typically an 80/20 division between equities and bonds, but the trust is currently at just under 90 per cent equities. That's because Mr Smith sees much more value on a yield basis in equities at the moment.
The trust has been trading at a consistent premium to net asset value and this stands at about 0.7 per cent.
As an investment trust, Henderson High Income has the option of using its revenue reserve to smooth out dividend payments to investors. As well as being able to grow the dividend, the trust has also been able top up its reserves for the past five years.
Mr Smith says: "Even though we've grown the dividend, if things get materially worse than we're expecting, and revenues come down and dividends are cut, we've still got that revenue reserve in our back pocket to be able to pay our own dividend."
