Investors continue to prize income, despite UK equity income funds falling victim to diminished sentiment towards the domestic market.
A glance at the top 10 holdings of most UK equity income-focused funds and trusts will largely paint a similar picture, of names well-known to the consumer. But the full holdings list may reveal some smaller companies that have the ability to growth their dividends over time.
Henderson High Income (HHI) takes full advantage of the market; the top holdings include British American Tobacco (BATS), Royal Dutch Shell (RDSB) and Diageo (DGE). However, it also invests in many lesser-known names such as Hilton Food (HFG) and Intermediate Capital (ICP).
We asked manager David Smith which three companies he has bought recently, and that he believes have the potential to grow their pay-out over time.
Tesco (TSCO)
After three years in the dividend wilderness, Tesco is back on the radar of income investors. Its 1p interim payout in October was its first since October 2014, with an expected final dividend of 2p on its way.
It’s a modest return to the dividend list, with the 3p total payment adding up to a yield of 1.45% for 2018. But broker UBS reckons that will grow in time to 8.58p per share in 2020, suggesting a forward yield of over 4%.
That’s predicated on new boss Dave Lewis, who Smith describes as “a very impressive CEO”, being able to continue the overhaul of the business he instigated when he took the helm in 2014. Smith says Lewis “talks a lot of sense” around his turnaround plan. “And when you look at the figures it does seem like they are gaining momentum.”
Lewis wants to get Tesco’s operating margin up to 3.5-4% over the next couple of years. In order to do this, he’s looking to slash costs. But, more importantly according to Smith, Lewis is making sure those cost savings are reinvested in the business. The aim of the reinvestment is to improve the quality of product, the quality of customer service and to remain competitive on price.
“Companies can get margins up by just doing cost savings, but that’s not sustainable,” says Smith. “But if they reinvest that into the business and drive that volume through the store estate then you get sustained margin improvement coming through over the long term.”
Currently, continues Smith, consensus forecasts see Tesco failing to hit its margin targets by 2020. As a result, the current price of 207p prices in the company failing to deliver. Smith thinks they will deliver. As does UBS, which is why its 12-month target price of 270p suggests upside of a third.
Smith also consoles himself in Tesco’s ongoing cash generation improvements. “Even if they don’t reach their margin target, they’re still going to be on a free cash flow yield of about 10%, which is still attractive and provides your downside protection from here.”
While the market is still tough, with Aldi and Lidl continuing to rapidly gain market share, “the market leader’s doing the right in terms of investing in their business to turn around the company”.
Shares are already 25% higher than its latest low in June 2017, and have re-rated 43% since the aftermath of the Brexit vote two years ago.
Ted Baker (TED)
Marks & Spencer (MKS) has long been an income favourite, but, along with many in the traditional bricks and mortar retail sector, has been experiencing a tough time lately. Falling sales due to a combination of negative real wages and the rise of online ecommerce aren’t helping and M&S has seen shares plunge 120% in less than three years.
Smith says the mid-market food and clothes seller has been feeling the pressure from both the budget players as well as the higher-end branded firms. As a result, he “lost confidence” and sold last year.
He replaced his holding in M&S with Ted Baker, which falls in the latter category of a high-end brand with a good-quality product.
“It’s expanding across in the US and Asia, so it’s a bit more diversified. It’s been investing a lot in terms of its IT infrastructure, in terms of its ecommerce online offering and also its distribution capabilities,” Smith explains.
The dividend is much more modest than M&S, at 60.1p per share in 2018 for a yield of 2.3%. However, there’s scope for that to grow, with broker Cantor Fitzgerald Europe forecasting 3.3% by 2021. Also, last year’s payout was over 2 times covered by earnings, as opposed to Marks’ 1.3 times.
Going forward, Smith says, you should start to see growth coming through as its investment begins to tail off. “You should see very strong free cash flow growth coming through, which should support very strong dividend growth at the same time.”
The trust bought Ted Baker in summer 2017. Between late June and early March 2018 the stock surged 40%. However, it’s seen a pull back since final results 21 days ago and shares are down a fifth. “But we still like it very much,” concludes Smith.
Schroders
While asset manager Schroders isn’t a stock well known for its income characteristics, Smith says he’s found an interesting anomaly between the voting (SDR) and non-voting shares (SDRC). Today, the non-voting trade at a massive 40% discount to the voting shares.
That discount has been around for a long time, but looks larger than it’s been for a few years. But what attracts Smith to the non-voting shares, which he picked up last year, is the yield.
Dividends per share paid by Schroders were 113p in 2017. That means the voting shares yield 3.5%, compared to the non-voting shares’ 5%. “That looks pretty appealing,” says Smith.
From a company perspective, “dare I say it, being at Janus Henderson, but Schroders is a good-quality fund manager”, Smith adds. “It’s well respected in the industry, it’s got a very strong brand and it’s very diversified both in terms of geography and the product itself.”
Shares have been pretty pedestrian in the short term, with share price returns of 4.5% and 1.1% from the voting and non-voting shares respectively over one year. Over three years, the voting shares are actually down 6%, though over longer timeframes they have performed well.
