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Yielding returns

John Baron reminds readers why the portfolios have an income focus relative to their benchmarks
April 6, 2017

Both portfolios have benefited from their 'total return' investment approach ever since their inception in January 2009 - in part, recognising that a focus on yield would help reap rewards in a low interest environment and the positive impact of reinvested dividends on portfolio returns over the longer term. As such, the Growth portfolio presently yields 3.3 per cent while the Income portfolio yields 4.7 per cent

Despite the prospect of modestly higher interest rates, such an approach will continue to do well - perhaps even more so. Such is this conviction that the majority of the seven real investment trust portfolios on the website www.johnbaronportfolios.co.uk have an income growth bias - with the equity-focused Dividend portfolio presently yielding 5.1 per cent, and the much more diversified Winter portfolio yielding 6.0 per cent.

 

Economic backdrop

Regular readers will be aware of this column's long held view that interest rates would remain low for longer than the consensus expected. A global economy weighed down by excessive debt was not going to rebound quickly. Short of a coordinated debt default, which is still possible, the world's central bankers have all but exhausted their armoury in trying to stimulate faster growth - including persistently low interest rates, quantitative easing (QE), and now negative interest rates in some quarters.

The effect on investment markets has been to unleash a search for yield - and the rising tide has lifted most boats. Since 2009, the portfolios have been overweight bonds via good quality higher-yielding corporate bonds, until August and September last year when they significantly reduced their lower-yielding holdings - the reasoning was that bond yields were not factoring in the likelihood that perceptions regarding future levels of inflation might become excessive.

Meanwhile, the portfolios' equity exposure also retained an income focus, while recognising certain 'growth' sectors needed to be included - examples being biotechnology and technology. Overall, this focus has been a positive even though 'growth' as an investment style has had the upper hand over the higher-yielding 'value' style during most of the past decade.

Even here, straws in the wind suggest the baton may be changing hands as economic growth gently accelerates - hence the portfolios' recent increase in 'value' stocks. As covered in previous columns, investors on both sides of the pond may yet come to be thankful to their electorates for filling the void left by the central bankers - President Trump's infrastructure, deregulation and tax cut plans, together with a weaker sterling post-Brexit, have helped lift sentiment.

 

 

 

 

 

 

 

 

Dividends versus capital gains

But there is another reason, beyond the fickle world of investment style, as to why the portfolios pursue an income growth bias - and it is all to do with company dividends. Behind the headline-grabbing news of stock and index price moves, lays a fundamental truth which is still not widely recognised - that dividends are by far the more important contributor to total returns over time than capital gains.

Finding and re-investing dividends is the key to healthy returns. All the evidence clearly demonstrates the extent to which this is true. The most recent Equity Gilt Study from Barclays Capital produces figures showing what £100 would be worth over different time frames to the end of 2013 if dividends had and had not been reinvested.

Since 1899, the figures are £28,386 and £191 respectively - a staggering difference. Although 114 years is beyond most peoples' timescale, the evidence still holds true over shorter periods. The figures since 2003 are £164 and £118 respectively - a near 39 per cent difference in over just 10 years.

Such figures can sometimes appear 'theoretical' - not relating to the real world. So it was interesting to see recent evidence from the Association of Investment Companies (AIC) - the organisation representing investment trusts - showing the extent to which this principle holds true for the UK Equity Income sector.

Data from the AIC using Morningstar shows that £100,000 invested into the average UK Equity Income investment trust on 31 December 1996 would have generated an initial annual income of £3,700 by 31 December 1997, and that this would have grown to an annual income of £8,516 in the year to 31 December 2016 - an increase of 130 per cent.

This represents annual dividend growth of 4.5 per cent, some 2 per cent ahead of inflation. Over the 20 years in question, investors would have received £119,872 of income. Furthermore, the capital value of the investment would have grown to £226,907 - an increase of 127 per cent. These are sound returns whichever way they are measured.

The message is clear: reinvesting dividends is the best way to grow wealth over time - and is less risky and time consuming than trying to time the market in the short term in an effort to make capital gains. To access these dividends, investors need to stay invested - the market rewards the patient investor.

An income bias is therefore not just for those who want an income. A focus on total return - capital gains plus dividends - yields the best returns. It can also tend to cushion portfolios from market volatility, provided the market believes the dividends are secure.

Investment trusts are well suited when it comes to this investment approach. One of their many advantages over their open-ended cousins is that they can retain up to 15 per cent of their income each year, as these reserves can be used to deliver dividend growth during what may be difficult times for others.

Furthermore, recent rule changes allow the payment of dividends from capital as necessary. Provided moderation prevails as to what is promised, 3-4 per cent being perfectly reasonable, no longer should hitherto low-yielding growth sectors be out of bounds to the income investor - recent sector examples include biotechnology, private equity and smaller companies.

 

Portfolio changes

During March, there were modest changes to both portfolios. The Growth portfolio added to its holding in Standard Life Equity Income Trust (SLET) while on a wider than average discount, and top-sliced JPMorgan Japan Smaller Companies (JPS).

Meanwhile, the Income portfolio replaced its holding in City Merchants High Yield (CMHY), when yielding 5.1 per cent and having enjoyed a good run, with a smaller holding in TwentyFour Select Monthly Income Fund (SMIF), which was yielding nearly 7.4 per cent when bought. Further details on SLET and SMIF, and the reasons for the trades, can be found on the above mentioned website.