Equity income funds are among the most popular investments for private investors, who have few other options when it comes to generating an income from their savings in a world of near-zero interest rates, yet the way in which funds generate the income – or ‘yield’ – that they produce is little studied.There is, instead, a focus on yield itself. Funds which generate a decent yield – anything above around three percent – are considered attractive, and those which are able to demonstrate that they have done so consistently are more attractive still, and there the analysis ends.
We think this is a poor effort. Yield is a factor of price. If a share costs a pound and pays a dividend of 10p it yields 10 per cent. If that share doubles in value and the dividend doesn’t increase (perhaps because the directors do not want to commit to a higher dividend which may not be sustainable) then the yield falls to 5%. Does that mean the income you receive goes down in absolute terms? No. Does it mean the share is a bad investment? Clearly not.
This issue came to the fore recently as the Investment Association was forced to reduce the somewhat arbitrary threshold yield requirement for the UK Equity Income sector, having launched a consultation after a number of constituent funds were given the boot for failing to meet the previous, higher target – falling victim to their own strong share price performance.
The weakness of yield as a focus is emphasised particularly in an environment where income is such a sought after quality, where valuations are irrational in many parts of the market, and where the outlook for dividends is so opaque – as we noted in our research last year.
DIVIDEND COVER ACROSS THE FTSE 350
Source: Research Tree
In fact, it is increasingly dangerous in areas such as UK equity income where many popular mega-cap stocks have very, very high yields, but whether or not they will actually pay that ‘yield’ is a completely different question given falling earnings growth and next to no revenue reserve cover. For example, while the yield across the FTSE 350 seems relatively attractive at 3.6%, as of December last year, dividend cover (a figure which shows the extent to which a share’s underlying earnings support the dividend it pays) was worryingly low at less than 1x.
So what other measures are worth considering?
Introducing Kepler Income ratings
We have devised a rating system which ‘scores’ trusts on a variety of characteristics which, in our view, are important for income investments. We have scored trusts across 16 different metrics, as the table below shows, and the final scores allow us to separate these trusts into quintiles – the top ‘rated’ funds being those in the highest quintile, marked with five ‘Kepler Orbs’.
It is important to stress that these ratings are not designed to identify ‘the best’ funds for income investors, or the ‘best’ funds overall. Indeed, some of the top performing funds in the AIC Equity Income sector – where our study is focused – score very poorly under these ratings, because while their total return has been strong, they have not performed well when looked at purely as income investments.
These ratings are designed to identify funds which serve a very specific purpose; to generate a real, dependable income without sacrificing capital, with a predictable trajectory. None of the funds we identify below should be viewed as a personal recommendation.
THE KEPLER INCOME RATINGS
*Effect of capitalised charges and dividends paid from capital
As the table also shows, to meet that very specific aim of identifying ‘income’ funds these ratings are weighted, with more points available over metrics such as dividend growth, the underlying portfolio income, the total amount of income paid out to shareholders, NAV capital growth (so the performance of the initial pot of savings if investors had taken the income each time), the amount of risk surrounding the performance of that capital and the current level of revenue reserve cover. Revenue reserves are funds kept aside by the board of a trust during stronger years, which can be used to smooth dividends during weaker years.
Yield has been taken into consideration (both the starting yield today along with the average yield over the past five years), but given we believe dividend growth, income generation and performance of capital are more important, it only carries a medium weighting in our ratings. It is joined by the number of years a portfolio has grown its dividend, the risks surrounding share price performance (as that has less to do with the manager than the NAV performance) and the combined hurdle rate per annum, which measures the effect of capitalised charges and paying an uncovered dividend on the trust. Effectively, this is the amount a trust has to grow by every year without eroding capital.
We have also taken into account the average level of revenue reserve cover over the past five years and whether or not managers and boards have been able to increase their revenue reserve cover over that time, though these carry the lowest Kepler Income Ratings.
Obviously, things change, and so we will rebalance the ratings annually to reflect this.
In this study we highlight the five AIC UK Equity Income trusts which have scored most highly according to our new ratings.
THE TOP-RATED UK EQUITY INCOME TRUSTS (QUINTILES FOR EACH METRIC) UNDER KEPLER INCOME RATINGS
Source: Morningstar/FE Analytics/Annual reports/Kepler Partners
PERPETUAL INCOME & GROWTH TRUST
Mark Barnett’s Perpetual Income & Growth trust has the highest score of any of the trusts we’ve looked at, sitting in at least first, second or third quintile for all the metrics we analysed. It is managed with a distinctly conservative approach and this is shown by its low levels of drawdowns and volatility, yet its higher allocation to mid-caps (certainly relative to its stablemate Edinburgh IT) means it has generated significant capital growth and dividend growth (6.52% per annum over five years).
Both its income generation and yield have been above average over recent years and the board have certainly helped with the trust’s overall income profile, given it has increased the dividend in each of the past 17 years and increased the revenue reserve cover over recent years to more than one year, according to the latest annual report.
Click here to read our detailed research note on the trust.
EDINBURGH INVESTMENT TRUST
Given Edinburgh Investment Trust is also managed by Mark Barnett using the same style of identifying companies with sustainable earnings and managing the trust with a total return approach and a clear focus on managing risk, it is hardly surprising that it sits alongside Perpetual Income & Growth in these ratings.
Its dividend growth, income generation and capital growth have all been above average for the sector, while it is among the top quintile for capital preservation, which is vital when analysing the sustainability of an income profile. Relative to Perpetual Income & Growth, it has produced lower capital growth and total returns, but has thrown off more in total dividends for shareholders.
Some may question its low current yield of 3.2%, but it has high levels of revenue reserve cover (1.03x) and it also has one of the lowest combined hurdle rates for the sector at just 0.43%.
Click here to read our detailed research note on the trust.
SCHRODER INCOME GROWTH INVESTMENT TRUST
Schroder Income Growth also receives the highest ratings. As manager Sue Noffke offers a strategy of blending higher-yielding shares, providing steady income, with lower-yielding shares that offer the potential for faster-growing dividends. It carries our maximum rating due to the fact it has scored well across the board, but in particular it has been among the highest scoring in the sector for its underlying portfolio income and its current revenue reserve cover, with revenue reserves currently equating to 116% of last year’s total dividend (the fifth highest in the whole sector). Its concentrated nature (it is made up of around 40 stocks) has contributed to it being more volatile than Mark Barnett’s two trusts, while its five-year dividend growth of 2.8% is below the sector average.
Click here to read our detailed research note on the trust.
CHELVERTON SMALL COMPANIES DIVIDEND IT
This is one of the highest-octane members of the peer group, focusing on (as the name suggests) UK smaller companies with a dividend yield of at least 4% at the point of investment. It is also structured as a split capital trust, with zero dividend preference shares currently in circulation.
It is 5-Orb rated due to the sheer amount of income it has generated over five years (almost double the sector average) whilst it has also generated the strongest capital growth, thanks largely to its focus on small-caps. However, this is a highly-geared investment trust and has been one of the most volatile and posted one of the largest possible drawdowns. Its dividend track record has also been relatively inconsistent.
Click here to read our detailed research note on the trust.
THE DIVERSE INCOME TRUST
Gervais Williams and Martin Turner’s Diverse Income Trust is another smaller companies fund.
Like Chelverton Small Companies Dividend, it has been among the best in the sector capital growth, but has protected capital more efficiently. It is a relatively young trust so it falls down in terms of years of dividend increases, yet its dividend growth is among the best in the peer group at close to 7% over five years. This is also an example of why yield can be a misleading metric, as while its average yield over five years has been among the fourth quintile, it has generated (and paid out) significantly more income than its average peer over that time frame – showing that a low yield can often be produced by strong capital growth.
So, as the board has paid a covered dividend (meaning it has distributed less to shareholders than the underlying dividends it has received) in each year since its launch in 2011, the board has already amassed revenue reserve cover of 0.8x the total 2016 dividend – which is almost unheard of for such a young trust considering its total dividend pay-outs over recent years.
Click here to read our detailed research note on the trust.
Future 5-Orb rated trusts?
The Kepler Income Ratings will be rebalanced annually and will therefore change over the coming years. As such, we are planning to profile two trusts that currently don’t carry our highest rating but, due to recent changes in the strategy, could be challenging the top quintile for our metrics over the coming years.
One of which is BlackRock Income & Growth, which now has a far greater focus on dividend growth thanks to Mark Wharrier’s appointment as manager in 2013. These changes have led to average levels of income generation, yet the strategy has yielded strong dividend growth over recent years and we believe it can continue to be one of the best members of the peer group for capital preservation.
Click here to recieve a copy of our research on this trust when it is ready.
The other is Standard Life Equity Income, as Thomas Moore admits he had to sacrifice a degree of income and yield when he rotated the portfolio from a more ‘core’ strategy to its current distinctive unconstrained mandate. Much of the hard work has now been done, though, as the board has rebuilt revenue reserves and are now committed to paying a higher proportion out to shareholders due to strong revenue growth.
Click here to recieve a copy of our research on this trust when it is ready.
