Is a bird in the hand really worth two in the bush? In the income sector, the choice is between a high income now, but little, if any, growth and moderate income with steady growth. In the former camp is the Merchants Trust (LSE: MRCH), the best-performing UK income trust over one year and second best over three and five. In the latter camp are the Troy trusts, Troy Income & Growth (LSE: TIGT) and Securities Trust of Scotland (LSE: STS), whose management Troy took over in September 2020.
The theory is straightforward: a portfolio that yields 2.5% with income growing at 10% per annum will yield 5% on cost after seven years. A portfolio that yields 5% is likely to have far less growth because its companies will have less to invest without borrowing. After seven years, it might still yield 5% on cost and is likely to have generated little capital return. The second portfolio will have generated a third less income, but should have doubled in value.
Merchants Trust has defied the theory, returning 14% over one year, 32% over three years and 43% over five compared with FTSE All-Share returns of 9%, 15% and 26% respectively. The shares trade at a tiny premium to net asset value, so the historic dividend yield of 4.8% reflects the portfolio yield and is nearly all covered by earnings. Low costs (just 0.55% of net assets) have helped, as have borrowings equivalent to 12% of net assets, but the dividend has been far from static, having been increased annually for 40 years.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
The portfolio has 50 holdings, of which 58% is in the FTSE 100 index, 29% is in the FTSE 250, 5% in small caps and 8% in overseas holdings or cash. The largest holding at 5% is GSK, while 4.1% each is held in the tobacco stocks BAT and Imperial Brands, although Imperial’s yield of 8.3% looks unsustainable despite a 33% dividend cut in 2020. Shell (3.9%) has been in the government’s firing line while Drax and Scottish & Southern (3.3% each) may have escaped the windfall tax. BAE Systems had 24 years of plodding performance until the share price jumped 30% on news of the Russian invasion of Ukraine.
Starting to turn around
Troy Income & Growth may have a lower yield of just 2.6%, but its total return – 5% over one year, 8% over three and 17% over five – has failed to compensate as one would have hoped.
However, Securities Trust of Scotland has made a good start under Troy’s management, returning 17% in the year to 30 April, 11% ahead of the MSCI World index. Its shares yield 2.4% and trade at a small premium to net asset value. Borrowings are 6% of net assets. The 33-stock portfolio has 30% invested in the UK, including four of the top ten. The largest of these is British American Tobacco – like Merchants Trust, it is keen on the tobacco sector. However, US-listed Philip Morris (5.4%), its second-biggest holding, is less financially challenged than Imperial. Other UK stocks include Diageo, Reckitt Benckiser, Unilever and Relx. North America is 54% of the portfolio, Europe 11% and just 2% in Japan (Nintendo).
James Harries, the trust’s manager, emphasises the importance of “investing in exceptional, resilient companies that grow the dividend, backed by genuinely surplus cash flow”. He concentrates the portfolio on favoured sectors, such as consumer goods, healthcare and business software, while avoiding those that are “structurally disrupted”, such as retailers, telecoms and life insurance – areas that many investors would traditionally have gone to for income. “We also view mining, energy, and aerospace and defence as unattractive, despite their being currently favoured by investors,” he says. “These areas are capital intensive, cyclical or both. Resource companies are dependent on a commodity price over which they have very little control and defence stocks are in the arms of government. Long-term returns on capital employed are low and volatile.”
There is a third way, followed by JPM Global Growth & Income (LSE: JGGI). It invests to maximise total returns, paying most of its 3.3% yield out of capital. This has produced index-beating returns of 60% over three years and 77% over five, and so it also trades at a small premium to net asset value. However, many income investors will be unhappy about dividends being paid out of capital.
Despite its strong record, Merchant Trust's portfolio does not inspire confidence, nor does its UK focus. The portfolio may change, but a radical shift looks unlikely. JPM Global Growth & Income still looks attractive, while Securities Trust of Scotland’s long sojourn in the wilderness appears to be over.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
Millions of mortgage borrowers will be hit with higher repayments next year
News Higher interest rates are yet to fully hit households and monthly mortgage repayments will rise between £200 and £1,000 – how much will your home loan go up by?
By Marc Shoffman Published
Halifax: House prices rise for the second consecutive month
UK house prices rose again in November, suggesting a resilient property market amid economic turmoil in the past year- are we heading for a crash?
By Vaishali Varu Published
Halifax: House price slump continues as prices slide for the sixth consecutive month
UK house prices fell again in September as buyers returned, but the slowdown was not as fast as anticipated, latest Halifax data shows. Where are house prices falling the most?
By Kalpana Fitzpatrick Published
Rents hit a record high - but is the opportunity for buy-to-let investors still strong?
UK rent prices have hit a record high with the average hitting over £1,200 a month says Rightmove. Are there still opportunities in buy-to-let?
By Marc Shoffman Published
Pension savers turn to gold investments
Investors are racing to buy gold to protect their pensions from a stock market correction and high inflation, experts say
By Ruth Emery Published
Where to find the best returns from student accommodation
Student accommodation can be a lucrative investment if you know where to look.
By Marc Shoffman Published
Best investing apps
We round up the best investing apps. Looking for an easy-to-use app to help you start investing, keep track of your portfolio or make trades on the go?
By Ruth Emery Last updated
The top funds to invest in
Tips Investors put Scottish Mortgage Investment Trust back on top, and India is the new investment hotspot - We look at what investors have been adding to their portfolios in the last month
By Vaishali Varu Last updated
The world’s best bargain stocks
Searching for bargain stocks with Alec Cutler of the Orbis Global Balanced Fund, who tells Andrew Van Sickle which sectors are being overlooked.
By Andrew Van Sickle Published
Revealed: the cheapest cities to own a home in Britain
New research reveals the cheapest cities to own a home, taking account of mortgage payments, utility bills and council tax
By Ruth Emery Published