In July research by investment platform The Share Centre revealed that dividend cover – the proportion of company profits paid out as dividends – had fallen to levels not seen since 2009, prompting investor concerns over the sustainability of UK payouts.
But Simon Gergel, manager of Merchants Trust (MRCH), argues that income investors should stop worrying about companies with stretched dividends, and instead start buying them because high yields and low cover can prove to be an opportunity. And he thinks a recovery among major banking, mining and oil stocks has repaired the pool of UK payouts.
"Dividend cover across the FTSE 100 always looks low when the oil companies are earning low returns," he says. "But recently they've been restructuring, cutting costs and becoming more efficient, and as they recover dividend cover improves. If you combine mining and oil companies you are probably looking at 18 per cent of the market suffering from depressed profitability, which has made overall FTSE 100 dividend cover look low recently.
>Being able to identify the companies able to weather a storm and continue to pay out income is at the heart of Mr Gergel's value-driven investment philosophy
"Banks are another big chunk of the market, and Lloyds Banking (LLOY) and Barclays (BARC) have both had problems that depressed profits when their underlying profits were much higher. I think it's a good opportunity to buy UK shares, even though it looks like dividend cover is thin, because as people get more confidence in those stocks the share prices will rerate."
An example of a bank Mr Gergel likes is HSBC (HSBA), the trust's fourth-largest holding. "18 months ago it yielded the best part of 8 per cent. A number of well-respected brokers said the dividend would be cut, but since then it's sold businesses and cut costs. Its shares are up 50 per cent over that period, and the yield dropped to 5.5 per cent and the cover improved. You can make a lot of money if you correctly identify the companies that will be able to maintain their dividends [amid share price pressure]."
Simon Gergel CV Simon Gergel is chief investment officer at AllianzGI and manager of Merchants Trust. Between 2001 and April 2006 he worked at HSBC Halbis Partners where he managed over £900m in high-income funds, and core institutional and life UK equity portfolios. Before this he worked for 14 years at Phillips & Drew/UBS Asset Management. He graduated in 1987 from Cambridge University with an honours degree in mathematics and is an associate of the UK Society of Investment Professionals. |
Being able to identify the companies able to weather a storm and continue to pay out income is at the heart of Mr Gergel's value-driven investment philosophy, and has helped Merchant's yield to remain consistently high – at time of writing it was over 5 per cent.
However, this approach doesn't always pay off in terms of total returns with, for example, the trust underperforming its benchmark, the FTSE All-Share index, in 2014 and 2016 – albeit with a double-digit net asset value (NAV) return of 13 per cent in the latter period.
But a flurry of short-lived rallies in value-style stocks propelled the trust's performance in the latter half of 2016 and so far this year. So over the first eight months of this year Merchants made NAV and share price returns of 8.82 per cent and 12.01 per cent, respectively, against the FTSE All-Share's return of 8.21 per cent.
Shares including HSBC, Equiniti (EQN) and cruise operator Carnival (CCL) have helped performance this year. Carnival's share price fell following the sinking of the Costa Concordia cruise ship and a power outage on the Carnival Triumph that left it stranded at sea for four days in 2013. However, since then its share price has expanded significantly.
But investors still prefer the kind of stock Mr Gergel does not buy, meaning that the trust has underperformed the FTSE All-Share over longer cumulative periods. The trust made NAV total returns of 16 per cent and 54 per cent over three and five years, behind the index's returns of 22 and 56 per cent, according to Winterflood.
Mr Gergel knows that his performance will depend on choosing stocks that can grow regardless of the wider market as his investment style means he is unlikely to surf a rising tide of market sentiment.
Stocks he is banking on include Greene King (GNK) and Ladbrokes Coral (LCL), which Mr Gergel believes are undervalued by the market. He also invests in recovery stocks and has recently added Bovis Homes (BVS), which he describes as the "cheapest UK housebuilder".
"The company expanded and tried to grow faster than it could, so quality deteriorated and costs got out of control," he explains. "The potential prize if they turn it around is significant – the shares could go up 30 or 40 per cent. Its shares are currently trading at a significant discount to the sector on a price-earnings ratio of 13.2 times."
In the meantime, Mr Gergel is satisfied that the trust's high income is secure. Merchants has increased its dividend for 35 consecutive years and its current dividend is well covered by reserves. The trust has a revenue reserve worth 94 per cent of the value of the dividend it paid in its last financial year, which Mr Gergel wants to build further. And he is not concerned that his ability to do this will be compromised by the level of UK dividends.
