Sources of yield may be scarce with the hunt for income going strong among many investors, but Alan Porter, manager of Securities Trust of Scotland (STS), a Global Growth & Income investment trust, is still adamant that chasing the highest yield is not the answer.
"Our objective is to provide an income return with some potential for long-term capital appreciation," says Mr Porter. "We prefer an income that grows rather than a high initial yield that inflation eats into if it doesn't grow. An income only strategy can lead you to high yielding stocks with value trap attributes: in these cases, for example, European telecoms, your income capital can be eroded. Some shares may have a high yield because the share price is going down or the market believes the dividend will be cut, and I don't want to own a company where the dividend will be cut."
To achieve this aim, Mr Porter focuses on high yielding companies that offer growing and sustainable dividends. He divides the high-yielding companies in his investment universe into four main dividend growth categories:
■ fast: greater than 7 per cent forecast three year dividend growth;
■ medium: 3 to 7 per cent forecast three year dividend growth, typically solid and low risk shares;
■ slow: less than 3 per cent three year forecast dividend growth, often from high yield stocks; and
■ cyclical: where dividends can be volatile and typically held when coming out of a recession.
"Over the last few years, the majority of our most successful ideas have come from the medium category," he says.
He will only buy a share if it yields more than the MSCI World average yield, currently about 2.6 per cent.
When selecting shares he focuses on areas including: yields on equities relative to other assets; the macro economic background; investors' cash positions; and the corporate situation and valuations, though he primarily selects shares according to their individual merits rather than economic, geographic or sector considerations.
"If dividends are to be sustainable, both profits and cash flow are key," adds Mr Porter. "And we never buy a share unless we feel it has upside to the current price. We consider it expensive if the current price suggests a more positive future than we think it has."
The portfolio is constructed along what he describes as a "barbell" approach whereby he mixes shares on different valuations, but has the majority of the portfolio, currently 34 shares, on "middle ground" valuations of between 10x and 15x price earnings ratios (PEs). Around eight are on single digit PEs.
"We think also consider: what is the market missing, what proof do we have of this, what therefore, are the signposts we are looking for to justify our investment thesis, what do we think the stock is worth and what are the risks to each of the above?" he adds.
Shares are sold if their yield falls 75 per cent below that of the MSCI World Index. "When a stock hits our target price if we no longer see any upside we exit."
Risk analysis is important because Mr Porter wants consistent performance and a higher quality portfolio than the benchmark, MSCI World High Dividend Yield Index, in terms of metrics such as return on equity, dividend cover and indebtedness. "We want a quality, growth and valuation margin of safety," says Mr Porter.
While he focuses on the 300 plus shares in his benchmark he will buy shares outside it, to own shares he thinks might move into this index in future. “We like stocks that will have persistent and sustainable dividends in the future," says Mr Porter. "Indices are backward looking, but we like to be on the front foot. Recent index changes mean that BSKYB, which we own, is going in and many financials, telecoms and utilities - none of which we own - are dropping out."
To be included in the MSCI World High Dividend Yield Index, shares need to be included in the parent index, MSCI World, but have higher than average dividend yields than the latter, and that are sustainable.
The UK is not enough
Securities Trust of Scotland has not always searched globally for dividends. Prior to August 2011 the trust had a UK focus. Mr Porter, who took over the trust from that date, says it would be much more difficult to run the portfolio with just a UK focus as there is far less choice of shares with the specific attributes he wants. There is also less choice of industries, for example few suitable IT shares, and not many mining and energy companies that fit the bill. "And if a given sector in your country stops paying dividends, for example as the banks did, you have a big problem,” he says.
Having a global mandate also avoids income concentration – many UK equity income funds have very similar top ten holdings.
Looking globally for income can offer good value: the MSCI World High Dividend Index has a forward PE of about 12.83 per cent against 13.58 for MSCI Word.
"There is a perception that investors are chasing high yield stocks and there is risk aversion, but that is a misconception," he says. "Since the 2009 rally started the three sectors which have been strongest are consumer discretionary, financials and industrials, while the three weakest have been utilities, telecoms and energy (three areas associated with paying dividends). High yielders have been laggards since 2009, so you can still find companies with a dividend at a discount."
