The income investor’s dilemma

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.

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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.

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