Investors should focus on companies that have the ability to deliver a sustainable and growing dividend if they want to outperform the wider market, according to Simon Gergel, whose Merchants Trust has increased its dividend in each of the last 32 years.
Gergel, who has managed the £700m Merchants Trust since April 2006, says investors are wrong to concentrate on the highest yielding stocks.To try and generate outperformance over the longer term, he instead looks for companies that have a strong dividend policy as he says that is the best sign it is a well-run business.
“Dividends are a very important part of total return,” Gergel (pictured) said.
“Companies that yield more than the average and can grow their dividend have tended to outperform over the longer term, which seems counterintuitive because you would think that companies that retain more money and invest for growth would do better.”
“However, it suggests that when company managements are flushed with cash they don’t tend spend it wisely whereas when they aren’t, they try to make every penny count. Dividend growth is, of course, an important part of the equation. However, finding companies that can grow their dividend is all about finding those that can grow their cash flow.”
As FE Trustnet highlighted earlier this morning, finding out about dividend information in the open-ended fund sectors is a very difficult task.
However, due to the fact that investment trusts are publically listed companies, data on their dividend histories is readily available to investors.
Trusts also have the advantage of being able to retain 15 per cent of their earnings each year, while OEICS and unit trusts have to pay out everything.
This means investment trusts can ‘smooth’ their dividend, as they can hold back earnings in good years to make sure they pay out more in bad ones.
Certain trusts have taken full advantage of this, like Bankers IT and City of London IT, which have increased their dividend in each of the last 47 years.
Source: The AIC
Though Gergel’s Merchants Trust doesn’t feature on that list, it has increased its distribution to shareholders in each of the last 32 years.
Since Gergel has been at the helm, the trust has grown its dividend from 18.9p per share in 2006 to 23.6p per share in 2014.
That annual increase is slightly above the rate of inflation in the UK.
Source: The Merchants Trust PLC
On top of that, due to Gergel’s heavy weighting to mega-cap stocks which lagged in last year’s bull market such as Royal Dutch Shell, GlaxoSmithKline and British American Tobacco, the trust currently has a 5.06 per cent yield, which is 1.5 percentage points higher than the FTSE 100’s yield.
This ability to grow its dividend has helped Merchants Trust to outperform since Gergel has been manager.
According to FE Analytics, the closed-ended fund has returned 56.53 per cent since April 2006, beating its benchmark – the FTSE 100 – which has returned 48.47 per cent over that period.
Performance of trust vs index since Apr 2006
Source: FE Analytics
The trust has also outperformed against its benchmark over three and five-year periods, but is down relative to the index over one year with returns of 2.04 per cent.
Nevertheless, it has beaten the FTSE 100 in all but three of the last eight calendar years; the exceptions being the turbulent markets of 2007, 2008 and 2011.
In a recent FE Trustnet article, Gergel highlighted that there were a number of potential value traps in the current market.
While he said that banks and commodity-related companies fall into that category from a capital value point of view, he also points out that investors can fall into yield traps if they simply look for companies that have the most attractive yields.
Though he says it can be an easy mistake to make, he adds that the best way investors can avoid that risk is by understanding the company they are investing in and analysing the environment it is operating in.
“It’s all about what is going on from an underlying business level. If it is a high yielding stock, the risk is that trading might be weak or there is the expectation that they will have to cut the dividend.”
“The point is that you want to find a company that is paying a sustainable and, ideally, a growing dividend. It is almost more important to understand the underlying business first, then its dividend policy second.”
As mentioned earlier, Gergel has a high weighting to mega-cap stocks.
His list of top 10 holdings includes the two oil majors, HSBC, Scottish & Southern Energy and BAE Systems. However, he attempts to add alpha by dipping into the FTSE 250 as well.
His three largest sector weightings are financials, services and oil and gas.
One potential issue for investors is that Merchants Trust is currently trading on a 1.7 per cent premium to NAV. That premium has fallen, however, as it has traded on 2.5 per cent premium at points over the last 12 months.
It is currently 19 per cent geared and has ongoing charges of 0.59 per cent.
