It is vital that investors don’t succumb to the “siren call” of high-yielding companies, according to James Dow of the Scottish American Investment Company (SAINTS), with co-manager Toby Ross calling it one of the biggest mistakes that income-seekers can make.
SAINTS is one of the AIC’s Dividend Heroes, having increased its dividend in every one of the past 39 years – only 10 trusts have beaten this record – and hasn’t cut its payout since 1938.
To maintain this record, Dow said it is vital that he takes a long-term approach to all aspects of the trust – and nowhere is this more important than in terms of income, which the manager defines as the total amount the trust can pay to shareholders over a multi-year time frame rather than a high headline yield.
“Our view is that in the income world there’s a great temptation for managers to, let’s say, succumb to the siren call of yield,” he said.
“It’s the stock in the portfolio yielding 5 per cent, which, you know, is looking a bit flaky, the management has just changed – but it has a 5 per cent yield, so you give it a pass and that’s a really bad thing to do for shareholders in the long term as it will inevitably fall apart.”
Most income investors will already be well-aware of the concentration risk they face in the UK market, with 30 per cent of the dividends paid by the FTSE coming from just three stocks – BP, Shell and HSBC.
In addition, 60 per cent of the dividends paid by FTSE stocks come from just six sectors – oil & gas, banks, tobacco, metals & mining, pharma and life insurance – that are characterised by low-growth prospects.
Looking outside of the UK allows SAINTS to diversify its sources of income – no industry accounts for more than 8 per cent of the trust’s dividend and the top six are responsible for just 40 per cent of its payout.
However, Ross said that while most investors accept the diversification benefits of looking overseas for income, they point out that SAINTS’ yield, currently 3.23 per cent, tends to lag behind the UK market’s figure – which is expected to push towards 5 per cent this year – and complain they are missing out on income.
“We think that is falling into one of the biggest traps that income investors fall prey to,” he warned.
“It’s confusing long-term income with short-term yield. In our experience, most of our shareholders are very long-term investors and what they want from SAINTS is a dependable and growing income that they can use to support their retirement over 10, 15 or 20 years.
“The yield on a stock this year is not a very big part of what will drive that income stream. What matters is the yield today times the growth rate of the business or the dividend stream, times by its resilience – how durable will it be in times of stress. You can’t read the growth and resilience off a fund factsheet or a Bloomberg screen, especially if you have a longer-term time horizon. But they matter just as much.”
To test this, Ross carried out some research looking at the difference in income you would have received over 14 years from UK equity income funds depending on their starting yield, going from 6 per cent at one end to around 3.5 per cent at the other.
The results showed the difference in the total amount of income generated by each of the buckets was negligible.
“So even though some funds had a yield that was nearly 80 per cent higher at the start, over 15 years the amount of income they generated was very similar,” said Ross.
“Why? The funds yielding 6 per cent ended up constrained in the highest-yielding parts of the market: the businesses they were invested in weren’t growing as fast and they were up to their eyes in banks, financials and resources companies which cut their dividends during the financial crisis.
“The funds yielding around 3.5 per cent were less constrained and had more ability to invest in growing businesses and avoid the riskier parts of the market.”
However, while there was no difference in the amount of income generated, there was a wide disparity in the amount of capital growth each category delivered.
“The lower-yielding funds that were less constrained delivered much better capital growth – we think that is quite instructive,” added Ross.
“It points out the dangers of focusing a bit too much on short-term income. You might get that income, but you are unlikely to get the growth.”
Data from FE Analytics shows Scottish American Investment Company has made 326.05 per cent over the past decade compared with gains of 222.71 per cent from the FTSE All World index and 220.3 per cent from the IT Global Equity Income sector.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
Someone who invested £10,000 in the trust 10 years ago would have made £8,119.76 in income alone over this time.
The trust is at a premium of 2.37 per cent to net asset value (NAV) compared with 3.89 per cent and 3.55 per cent from its one- and three-year averages. It is 18 per cent geared and has ongoing charges of 0.78 per cent.