Spotlight - June 2020
In this issue of Spotlight, we look beyond the usual UK and global equity suspects to find investment companies with appealing income characteristics.
Is the very concept of equity income outdated? In a recent column for the Financial Times, Terry Smith argues that the best approach “is to invest for the highest total return you can achieve and sell whatever shares or units you need to provide cash”. I have heard some advisers make a similar argument.
Dividend cuts at many blue chip household names have given extra ammunition to the advocates of a ‘pure total return’ strategy. Certainly, the approach of relying on company dividends offers no guarantees, any more than any other form of investing – though investment companies have revenue reserves to cushion blows such as COVID-19.
But relying on achieving a certain level of total return has its very obvious problems too, especially for those looking to fund their retirement. Even if those returns are achieved, on average, over a long period, an unlucky sequence of returns could spell trouble for a retiree. Hence the enduring popularity of income-producing investment companies, which allow investors to ‘outsource’ the job of smoothing income over time to the fund manager and board, in the same way as they choose to outsource the stock selection.
The good news is that the investment company investor now has a wider range of income options than ever before. This month in Spotlight, we have asked analysts to look beyond the obvious income sectors (UK Equity Income, Global and Global Equity Income) and name their top picks for attractive, reliable income streams – Asian equities and infrastructure feature strongly. Meanwhile, David Prosser chews over that Terry Smith column and asks whether investment companies could still have a role for investors who choose to follow Smith’s advice.
Normally, at this time of year, I’d be wearing out shoe leather in a training tour of the UK, renewing my intimate acquaintance with railway stations and hotel restaurants. Corona put a stop to all that, but we have been working on bringing you an alternative that will be online, but live. This will supplement our existing (on-demand) online training in Learning Zone.
So in July we are running a series of four webinars, Investment trusts explained, which will aim to do just that. Perhaps you, or a colleague, will be able to join us for the sessions. While the webinars are designed for those with little or no prior knowledge of investment companies, we will be covering some new material – including the impact of COVID-19 on investment companies – so there should be something for you even if you’ve attended our sessions before.
Finally, I would draw your attention to the last article in Spotlight, which looks at what investment companies and their portfolio holdings have been doing to support front line workers and small businesses during the COVID-19 pandemic. It’s a heartening read.
I hope that as lockdown eases, you’re able to take advantage of the extra freedom that brings while staying safe. As ever, do get in touch with any questions or comments.
Nick Britton, Head of Intermediary Communications, AIC
9-21 July - Investment trusts explained
A series of four 45-minute webinars presented by Nick Britton that will explain all you need to know about investment trusts.
Analysts pick their favourite income-paying investment companies beyond the dividend heroes
With HSBC, Shell and BT among the many income stalwarts cutting or suspending dividends and interest rates remaining near all-time lows, income investors face an arid environment.
The ability of investment companies to reserve up to 15% of their income each year has helped them to carry on raising dividends through such intense market downturns as the 1987 crash, the dot com bubble bursting and the financial crisis. Companies in the UK Equity Income, Global and Global Equity Income sectors are particularly well known for this, and dominate the AIC’s list of ‘dividend heroes’.
However, these are not the only sectors generating healthy yields and reliable income streams. The AIC has spoken to investment company analysts to find out which other investment company sectors they consider for income.
Looking east: Asian equity
Anthony Stern, Analyst at Stifel, said: “We think the Asia Pacific Income funds offer a different source of income. Asia was the region first into the COVID-19 crisis and the first out. The Asian funds offer dividend yields of 5% or more and these dividends are fully covered by revenue income, unlike some trusts in the investment company world. The funds have been recognised for increasing their dividends over the long term and are part of the AIC’s next generation of dividend heroes. All of the funds have substantial revenue reserves which should allow them to maintain their dividends through their lean times.
“Aberdeen Asian Income is clearly the value play in the sector at a 13% discount and offering a 5.5% dividend yield. Schroder Oriental Income has been managed since inception by the highly experienced Matthew Dobbs. It has one of the best track records of the Asia Pacific Income funds on a total return basis and offers a dividend yield of 5.3%.”
Anthony Leatham, Head of Investment Trust Research at Peel Hunt, said: “Outside of UK and Global Equity Income, there are a number of sectors and regions that offer attractive yields. We would highlight the differentiated equity income story in Japan. Richard Aston has been manager of CC Japan Income & Growth Trust (CCJI) since its launch in December 2015, boosted by the focus on shareholder return from Abenomics. CCJI currently offers a yield of 3.8% and an unconventional sector mix versus other developed market equity income strategies.
“Healthcare has historically been a valuable source of equity income for investors. However, this can be at the expense of capital growth. BB Healthcare pays its dividend out of capital and currently offers a yield of 3.0%. The benefit of this approach is that it allows the managers to adopt an unconstrained and high conviction approach, without being tied to the high-yielding, often ex-growth stocks in their universe.”
Firm foundations: infrastructure and social housing
Alan Brierley, Director of Investment Companies Research at Investec, said: “Sustainability of income is key and our preferred sector is Infrastructure. Our recommendations include HICL Infrastructure, The Renewables Infrastructure Group, Greencoat UK Wind and Sequoia Economic Infrastructure Income. These companies give a diversified exposure to social, economic and renewable infrastructure along with infrastructure debt. Within the debt sub-sector, many constituents had over-promised and under-delivered even in a benign credit environment before the onset of the pandemic. Here, stock selection is even more critical – our preferred investments are GCP Asset Backed Income, which invests in asset-backed loans, and BioPharma Credit which provides debt capital to the life science industry.”
Monica Tepes, Head of Investment Companies Research at finnCap, said: “If you are looking for as much certainty as possible that your dividends are not going to be cut, I think you need to look at sectors where either the local or state government is your counterparty, or your payments come from businesses which are unaffected or even benefit from the current environment. In the first category I can only put infrastructure equity (BBGI, International Public Partnerships, HICL Infrastructure), infrastructure debt (GCP Infrastructure Investments, Sequoia Economic Infrastructure Income) and supported living (Civitas Social Housing, Triple Point Social Housing REIT). In the second category I think there are no clear winning sectors – certain players in the logistics sectors seem to be in the right assets, but others aren’t. If the products transiting through your logistics centres are not selling, you will have trouble collecting rents.”
Conor Finn, Investment Fund Analyst at Liberum, said: “Aside from Infrastructure and Renewable Energy Infrastructure funds, we believe the social housing REITs offer the prospect of long-term, uninterrupted income. Following recent acquisitions, Civitas Social Housing has achieved full dividend cover on a forward-looking basis and we expect an increase to cover of 1.08 years by Q1 2022. The portfolio produces a long-term, inflation-linked income stream from specialist supported housing. Civitas is focused on accommodation for individuals with care needs that are moderate to high. Rental payments from housing associations are funded from housing benefit. Rent collection in the sector has been unaffected by the COVID-19 crisis, unlike other real estate.”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “The investment companies I have highlighted generate their income from a range of asset classes with different underlying return drivers. In addition, they have diversified portfolios with a large number of underlying investments. For example, International Public Partnerships has over 100 projects in the UK, Europe, North America and Australia, including public private partnership projects such as schools, courts and police stations as well as offshore transmission cables, transport assets and the Thames Tideway Tunnel project. TwentyFour Income offers exposure to both mortgage and corporate loans across Europe, backed by thousands of underlying loans.”
But what about the risks?
Simon Elliott, Head of Investment Research at Winterflood Securities, said: “With any investment trust investing in equities overseas for income, there is always the potential for adverse currency movements. These can be meaningful and counter any increase in the level of the underlying dividend, however, this obviously works both ways. Sterling has proven relatively weak in general so far this year, which provides a following wind for overseas equity income mandates.”
Conor Finn, Investment Fund Analyst at Liberum, said: “The regulator has been critical of the social housing sector and has highlighted issues at a number of housing associations. The counterparties to the leases are typically smaller housing associations. Civitas Social Housing has been working with the housing associations to address the issues raised. Civitas has led several initiatives to improve professionalism and the long-term sustainability of the sector. These include force majeure clauses in the leases, assisting housing associations with governance changes and board appointments and supporting the establishment of a not-for-profit, community interest company. On a portfolio level, Civitas has also been working on increasing the amount of the portfolio that is supported by 25-year, back-to-back care provider leases which represent 30% of the portfolio.”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “The risks vary widely according to the nature of the underlying assets. International Public Partnerships has modest exposure to regulated assets, some of which are subject to periodic price controls where the regulator sets the allowed return. A small part of the portfolio has some demand risk, although there are various downside mitigations within certain contracts which provide some comfort. However, the majority of revenues have a high level of predictability under availability-based payment structures, or through senior debt investments. TwentyFour Income could be exposed if default levels in European loans or mortgages are significantly higher than expectations, although there is typically first-loss protection and current valuations are pricing in an increase in defaults.”
Anthony Leatham, Head of Investment Trust Research at Peel Hunt, said: “There has and will continue to be dividend disruption facing the market as a result of COVID-19 and its economic impact. Revenue reserves have helped investment companies to deliver income to shareholders through periods of stress and we expect to see this play out again. Volatility may also give certain investment companies more opportunity to use option strategies to enhance the income generated by their portfolios. In addition, investment companies can employ gearing to take advantage of market dislocations, boosting the yield. Finally, the closed-ended structure protects portfolio managers from becoming forced sellers. Open-ended fund managers have had to deal with redemption requests and this can have a detrimental impact on portfolio performance and income generation.”
Monica Tepes, Head of Investment Companies Research at finnCap, said: “The scarcity of income is nothing new and the economic backdrop of ultra-loose monetary policy is going to make income-producing alternative assets even more attractive. The investment company alternative income sector has grown tremendously over the last 15 years precisely because it can fill this gap, which open-ended funds, equities and bonds can’t. I think there will be more income solutions to come from this space.”
A different approach to income
David Prosser responds to recent comments from Terry Smith about income investing
Fund manager Terry Smith has a long history of making uncomfortable arguments that the financial services industry doesn’t want to hear. Almost 30 years ago, following the publication of his book, Accounting for Growth, he was fired from his role at a leading investment bank; his exposure of the accounting techniques used by a bunch of companies that blew up in spectacular fashion is one of the best and most accessible books you’ll read on the City, but it washed rather too much dirty linen in public for some people’s liking.
Today, after a decade of running Fundsmith, the fund management firm he launched in 2010, Smith remains as forthright as ever. The latest target in his sights is the idea of equity income; his Financial Times column last month warned “no one should invest in equities for income”. Yikes.
To offer a little more nuance, Smith’s argument is that even before the Covid-19 crisis prompted so many companies to slash their dividends, the distributions that many of them were making were not sustainable. He expects many companies will take this opportunity to move to smaller dividends in the future.
That may be no bad thing if it enables more companies to retain earnings for investment in growth. But where does it leave investors seeking income, particularly at a time when interest rates are at unprecedented lows and yields on pretty much every asset class look paltry? Interestingly, Smith has two suggestions – both of which play to the strengths of the investment companies industry.
First, he suggests income seekers simply focus on capital growth, investing for the best total return possible; then, he points out, there is nothing to stop them cashing in part of this growth in order to secure an income.
This, of course, is one of the unique attributes of the investment companies sector. Unlike other types of collective investment fund, investment companies have the right, with shareholders’ permission, to pay income from capital, rather than funding all distributions from dividends earned by the portfolio. Effectively, such funds are doing exactly what Smith suggests.
Smith’s second suggestion, made thinking of investors who baulk at the idea of swapping capital for income, is that income seekers should look for companies where there is an opportunity to invest alongside a family that has a controlling shareholding in the business. Often, he points out, these families rely on the dividend income generated by their companies, which helps guarantee its flow.
Where might you find such companies? Step forward the closed-ended fund industry once again. There are a number of long-established and successful investment companies where the shareholder base is dominated by a single family, alongside which the public is free to invest. Leading examples include Caledonia Investment, 44% owned by the Cayzer family, Majedie, where the Barlow family owns a similar-sized stake, Brunner, where the eponymous family remains significantly invested, and Manchester & London, majority-controlled by the Sheppard family.
Investors and advisers sometimes worry about investing in family-owned companies and funds; they may have concerns about governance structures and there may be questions over whether the interests of all shareholders are always aligned. Still, these particular funds have impressive long-term performance track records.
The broader point here though is that in so many other areas, the investment companies industry offers some unconventional solutions for investors worried about income, particularly in the challenging environment in which we currently find ourselves.
Doing our bit
How investment companies and their holdings are supporting front line workers
For the past few months at 8pm every Thursday the UK has stepped out on to front doorsteps and balconies to clap for our carers. This simple act of appreciation and support is being matched around the world by people and companies doing what they can in the fight against COVID-19.
Many companies are working to develop tests and treatments for coronavirus but there are lots of other ways businesses have been showing their solidarity and support. The AIC has spoken to its membership to see what investment companies and their portfolio holdings have been doing aside from testing and treatments to support the global initiative. Responses range from providing free data for health workers in Turkey to donating face masks to the NHS.
Annabel Brodie-Smith, Communications Director of the AIC, said: “It’s heartening to see how investment companies and their portfolio holdings have been helping during the COVID-19 emergency. The help has included donating PPE, offering services for free and providing support and advice to small businesses. Investment companies have over 150 years of heritage so they are no strangers to extraordinary times. It’s good to see investment companies and their holdings helping today.”
Face masks for the NHS
James Armstrong, Managing Partner of Bluefield Partners, the investment adviser of Bluefield Solar Income Fund, said: “We were pleased to partner with our Chinese friends, LONGi Solar, on a local PPE initiative. In April, we were contacted by LONGi, the Shanghai based solar manufacturer, asking whether Bluefield needed any PPE for our teams operating in the field. We said yes and 2,000 face masks arrived. Our teams only needed a few hundred so we were delighted to donate 1,600 masks to the Royal United Hospital (RUH) Bath who are on the front line fighting COVID-19. My twin sons were born in the RUH almost exactly 12 years ago. It’s nice to be able to give something back to the wonderful staff at the hospital. Bluefield would like to thank them for the amazing work they are doing.”
Volunteering to help entrepreneurs
Tim Levene, CEO of Augmentum Fintech, said: “Augmentum is perhaps unusual amongst most investment companies as our entire portfolio is focused on fintech. As such our portfolio companies have been at the centre of much of the COVID-19 response, and given they are all technology companies, the response has been rapid. Habito’s online mortgage and re-mortgage services were able to ensure customers could make progress whilst in lockdown, iwoca are offering CBILS [Coronavirus Business Interruption Loan Scheme] loans, Tide are offering Bounce Back Loans, as well as having launched a coronavirus assistance hub to support small businesses during the pandemic and Farewill are supporting key workers with free wills for NHS staff.
“As a fund we have been working closely with our portfolio companies and inputting on government initiatives such as the Future Fund. Our partners have been hosting 1:1 Office Hours sessions with early stage fintech founders to support the wider industry and to ensure innovation continues and start-ups can continue to scale when they are ready. We also launched TeenVC, a free digital education platform where teenagers can learn about venture capital and entrepreneurship, at a time when teenagers are at home and parents and schools are looking for online educational activities.”
Free data for health workers in Turkey
Matthias Siller, Co-Manager of Baring Emerging Europe, said: “A company we invest a meaningful amount in, which provided an exemplary response to the COVID-19 related humanitarian challenges, is Turkcell, the leading mobile network operator in Turkey. Whilst not directly involved in the production or distribution of PPE or other healthcare equipment or services, we believe that the swift and non-bureaucratic actions taken by management to support businesses, individuals and households in dealing with the pandemic set a standard for other companies to aim for. Some of the key initiatives worth mentioning include hygiene equipment for field employees as well as free data allowances for university students, subscribers in the health sector and subscribers aged over 65 to facilitate remote working, online education and connectivity.”
The £50,000 “Wage War on Covid Fund”
Robin West, Co-Manager of Invesco Perpetual UK Smaller Companies Investment Trust, said: “We always seek to invest in well-managed, quality companies. One characteristic of a strong management team is an understanding and awareness of how the business interacts with and affects all its stakeholders: staff, customers and the wider community as well as shareholders. We are pleased to see how some portfolio companies are responding to the COVID-19 pandemic, which has increased awareness of the social ‘S’ component of ESG. Consultant engineers Ricardo have engineered and assembled face shields which were donated to workers in care homes and NHS facilities local to four of the company’s UK sites; Inspecs Group is an eyewear manufacturer which has diverted its production to supply safety eyewear to frontline medical professionals; and investment platform AJ Bell has launched a ‘Wage War on Covid Fund’ under the umbrella of the AJ Bell Trust, a registered charity, which has allocated £50,000 to the fund. In addition, directors and senior management have donated their April, May and June salaries, alongside other members of staff making similar pledges.”
Supporting cancer care
Ben Wicks, Fund Manager of Schroder UK Public Private Trust, said: “Rutherford Health is the very best of British. It is the first national provider of proton beam therapy, giving patients access to the most advanced form of cancer care within the UK. This is especially beneficial for children, the elderly and patients with a weak immune system. The firm has partnered with the NHS to provide care to patients at a time when many NHS healthcare facilities are dealing with a high number of COVID-19 patients.”