The re-investment of dividends is one of the key stepping stones to investment success. But there has been a tendency by investors to overly rely on large UK companies to generate this income. Dividend cuts by FTSE 100 companies in recent years have reminded us of the importance of diversifying one’s income generation - both by looking to smaller companies at home, and by looking abroad.
Regular readers will know that I have long advocated the importance of staying invested and not trying to trade market volatility in the hope of making short-term capital gains – I leave that to wiser investors. But there is another reason to stick with the markets. Over the longer term, it is dividends – and not capital gains – that have produced the lion’s share of market returns. Finding and re-investing dividends is key to healthy returns.
Legendary investor Jeremy Siegel illustrated the point well in his book ‘The future for Investors’ (Crown Business, 2005). He calculated that, over a 130-year period, as much as 97 per cent of the total return from US stocks came from re-invested dividends. The figures were revealing. $1,000 invested in 1871 would have been worth $243,386 by 2003. This figure rises to a staggering $7,947,930 had dividends been re-invested.
The message is clear: the better returns over the longer term come from not spending your dividends. And to access these dividends, investors must stay invested.
But, historically, income-hungry investors have tended to focus on the largest companies to help generate this income. This is in part because they are deemed safe and because the FTSE 100 accounts for nearly 90 per cent of all dividends generated by the FTSE All-Share. Yet recent dividend cuts from BP, the banks, Centrica and others have highlighted the danger of this approach.
To help reduce this risk, both portfolios are invested in trusts seeking to generate a decent level of income from abroad– including Henderson Far East Income (HFEL), European Assets (EAT), and Utilico Emerging Markets (UEM). At home, this diversification is assisted by exposure to smaller companies, via Acorn Income (AIF), the Commercial Property sector and bonds.
But I suggest further exposure to UK smaller companies is warranted. This is because the larger company pay-out ratios are at high levels, and so the margin of safety has narrowed somewhat in recent years when it comes to their ability to sustain and grow dividends going forward.
By contrast, smaller companies enjoy healthier balance sheets. This should help them to build on their impressive track record when it comes to dividend growth. Over the last 29 years since the FTSE 250 index came into being, the index has produced annual dividend growth of 7 per cent compared to less than 4.7 per cent for the FTSE 100. Meanwhile, smaller companies in general look attractively rated relative to their earnings growth given the economic recovery is in its early stages.
So, in addition to reducing the risk of being over-dependent on the largest companies for income, smaller companies look set to continue producing better dividend growth going forward. Investors should ensure they access this potential.
Standard Life Equity Income Trust
To this end, I have introduced Standard Life Equity Income Trust (SLET) to both the Growth and Income portfolios during May. SLET’s objective is to achieve above average income whilst providing real growth in both capital and income - the benchmark being the FTSE All-Share Index.
Like other investment trusts in the UK Income Growth sector, it used to focus on the larger companies when seeking dividends. However, concerned about the extent of dependency on a relatively few large companies, in November 2011 the Board changed the strategy to include a larger proportion of smaller companies where the manager had a high conviction.
At the same time, Thomas Moore took over as manager. Since then, SLET’s performance has improved markedly both relative to its peers and the benchmark. Indeed, the NAV has risen 82.9 per cent compared to 47.7 per cent for the benchmark up to its latest half-yearly report dated 31 March 2015 – both percentages being total return.
This strategy change has been meaningful. When instigated in November 2011, SLET’s exposure to the FTSE 100, FTSE 250 and FTSE Smallcap indices was 75.8 per cent, 22.3 per cent and 1.9 per cent respectively. By March 2015, this had changed to 33.3 per cent, 48.1 per cent and 18.6 per cent. By way of comparison, the FTSE 100 index today is 81 per cent of the FTSE ALL-Share index. Over the same period, the dividends produced for SLET by its top 10 investments declined from 50.3 per cent to 28.9 per cent.
The change in strategy and fund manager has rewarded investors well. Speaking with Mr Moore, the move to the mid and small caps took nearly two years, and initially hit the running yield, but now the trust is in a sweet spot. Companies with good fundamentals and sound balance sheets are sought, with initial yield being a secondary consideration.
Such an approach, helped by its increased exposure to smaller companies, makes for healthy dividend growth. SLET has just increased its interim dividend by over 6 per cent, whilst yielding 3.3 per cent at time of writing (assuming a minimum dividend of 14.6p), and has over one year’s worth of dividends in its revenue reserves. This bodes well for the future.
Furthermore, Standard Life has the expertise in house to ensure Mr Moore and his team is well served when it comes to stock selection across the market cap spectrum, with an excellent smaller company team led by the well respected Harry Nimmo.
But I suggest SLET serves an additional purpose – that of helping to provide an element of ‘discretion margin’. My Investors Chronicle portfolios each contain a few holdings which possess the discernible flexibility to help mitigate my investment view should it be wrong. This is helpful as I wish to stay invested in the markets.
If it turns out that I am wrong about the dividend paying potential of smaller companies, then SLET will hopefully recognise this and re-orientate the portfolio towards the larger companies – thus at least partially compensating for my error. If we are both right, then the portfolios will doubly benefit. Such holdings perform an important role in portfolio construction and in assisting with portfolio balance.
In short, a good fund manager, a good strategy, the promise of good dividend increases, and superb performance combined with a somewhat harsh discount of 6 per cent, all warrant the inclusion of SLET in both portfolios.
Other portfolio changes
To fund the purchase of SLET, I have sold both portfolios’ holdings of Murray Income Trust (MUT) whilst standing on a similar discount. It has been a solid performer, but the time has come to move on.
