The Link Dividend Monitor, a survey of UK equity dividends, reported that over the first quarter of this year UK dividend underlying growth of 5.5 per cent was weaker than expected. But David Smith, manager of Henderson High Income Trust (HHI), is not too concerned.
"I don’t think we are going to see high levels of dividend growth, but there should be growth – probably low to mid single digits," he says. "Payout ratios for the market in general are in line with the historical average.”
He highlights the banking sector, where there were large dividend cuts during the financial crisis of 2008-09. “The banking sector has been completely recapitalised and dividends are growing again to more attractive levels,” he says. “So even if the UK heads into recession, I think dividends are now more sustainable. The tobacco sector, in particular, is very attractive. Imperial Brands (IMB) yields 7.99 per cent and British American Tobacco (BATS) yields 7.01 per cent. These companies haven’t reached these levels since the late 1990s, when there was a lot of regulatory uncertainty. There is still regulatory uncertainty, but when we do our stock analysis on the businesses I still think they have incredible cash flows that cover the dividends well, so you would have to be very bearish on any regulatory outcomes in the US to believe that the cash flows couldn’t cover those dividends [meaning they] should get paid. And shareholders should see a strong rerating from that.”
He also invests in smaller companies. “Some of our FTSE 250 holdings such as Hilton Food (HFG), Big Yellow (BYG) and Intermediate Capital (ICP) have been growing their dividends at double-digit rates and we think this can continue for the foreseeable future," he says.
But Henderson High Income Trust is not purely focused on UK equities. At the end of March, 88.1 per cent of the trust’s assets were in the UK, with 9 per cent in the US and 1.1 per cent in Switzerland.
“The UK pharmaceutical sector is quite concentrated in terms of number of stocks,” he explains. “But investing overseas gives you the ability to diversify within that sector, so I own Roche (ROG:VTX) and Sanofi (SAN:PAR) – Swiss and French pharmaceutical companies. These increase the trust’s exposure to more defensive sectors and by looking overseas you don’t have too much concentration.”
A number of the US holdings, meanwhile, are bonds because Henderson High Income Trust can also allocate to this area. It has around 85 per cent of its assets in equities and 15 per cent in bonds.
“The problem in the UK is that investment-grade corporate bond yields are particularly low,” says Mr Smith. “However, in the US market we are able to buy good investment-grade bonds issued by the likes of Amazon (AMZN:NSQ), McDonalds (MCD:NYQ) and defence company Lockheed Martin (LMT:NYQ), offering yields of around 4 to 4.5 per cent.”
The trust invests in bonds to increase its overall income and has a yield of around 5.6 per cent. Getting income from bonds also means that it doesn't have to invest in very high-yielding low- or no-growth companies. “I can own lower-yielding names that offer more capital appreciation, such as Diageo (DGE), RELX (REL) and Cranswick (CWK), whose capital return story over the longer term seems very attractive. The other benefit of owning some bonds is that through an investment cycle they dampen down the overall volatility of the trust as they are typically less volatile than equities.”
For example, in 2018 Henderson High Income’s bond portfolio fell 0.7 per cent in contrast to the FTSE All-Share index which was down 9.5 per cent. However, the trust overall did not have a good year, with its net asset value (NAV) return down 13.9 per cent, although over the longer term it has a good record.
“Stock selection within the UK equity portfolio was disappointing,” says Mr Smith. “In a tough market for equities, our financials holdings, in particular the asset managers such as Jupiter (JUP) and Standard Life Aberdeen (SLA), were particularly poor performers. Falling markets are never good for asset managers and there were other issues such as outflows and margin pressures. Also, some of the more traditional income sectors such as tobacco and telecoms, which are very good for income, were disappointing in terms of capital [growth]. The other reason [for our] underperformance was the gearing (debt) within the trust. Gearing gives you a benefit over the longer term, but in weaker markets it accentuates falls in NAV.”
The trust has a relatively high level of gearing of about 24 per cent. But Mr Smith argues that around three-quarters of this has been used to invest in bonds to boost the trust’s overall income, and these traditionally have been more stable than equities. And so far this year performance is looking better, with the trust's NAV return up 16 per cent over the first four months of the year, ahead of the FTSE All-Share’s rise of 12 per cent.
But Mr Smith is concerned about whether the global economy is slowing and UK political risks. So he has been making the trust more defensive by increasing its allocation to bonds and adding more defensive holdings such as pharmaceuticals and consumer staples. "Unilever (ULVR) is a good example of a defensive name which sells everyday items,” he explains. “People are unlikely to go without them even if times are tough for disposable income. [But] UK valuations [of some domestic facing companies] are attractive, so there is still a place for them. But [when we invest in] domestic cyclicals we try to focus on the really good quality ones with strong brands, strong market leader positions, good business models and robust balance sheets. In a no-deal, hard Brexit scenario these companies should survive and probably thrive into the longer term. And in a softer environment they should still outperform.”
Quality, domestic-facing cyclicals he likes include Whitbread (WTB), owner of the Premier Inn hotels.
“This is market leader in terms of budget hotels in the UK,” he says. “It’s a strong, recognisable brand, and has got a consistent offering, very robust balance sheet and freehold backing – it’s a good quality name. The short-term outlook for the business is tough. But given the valuation it is on at the moment, when you look at the fundamentals and the strength of the business, I think it is a good investment for the very long term.”
Listen to the audio version of our interview with David Smith, manager of Henderson High Income Trust
