How to find top-quality income picks in the UK stock market

Income is crucial to many investors and, over the long term, has been a major component of total return. Yet delivering high levels of income comes with challenges. It is easy to be tempted to own stocks that are overdistributing their profits as dividend payouts, while high-quality or high-growth stocks are generally priced accordingly, with low or non-existent yields.

Shires Income Trust applies a differentiated approach to income investing. We have 20% of the portfolio in high-yield preference shares. These deliver stable income but also allow us to diversify the equity portfolio, providing scope to hold companies with strong growth or dividend growth potential.

The portfolio is further differentiated by a genuine multi-cap approach and the ability to hold overseas equities. The closed-end structure of the fund also allows us to use leverage to enhance income and allows us to genuinely invest for the long term. When looking for equity positions, we are style and size-agnostic, but we look for first-rate firms. A common problem, however, is that quality companies are often readily apparent and valued accordingly. That limits upside, but also creates risk: if things go wrong, there is a long way to fall, so we are always on the lookout for quality that is not recognised.

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Where to invest in the UK stock market

UK contractors such as Kier (LSE: KIE), a construction and civil engineering specialist, are an excellent example of this. After a period of excessive risk, leverage and insolvencies, the industry has reduced the risk inherent in its contracts, significantly improved balance sheets and consolidated. The result is a sector where returns are much improved and businesses are growing. The need for investment in the UK over the next 10 to 20 years bodes well for the long term. The large contractors have strong pipelines. They can pick the best contracts and protect returns, yet earnings multiples do not reflect this.

Going down the market-value spectrum is also a good way to find underappreciated quality stocks. A recent addition I like is ME Group (LSE: MEGP). The company operates photo booths and automated laundromats. While that may not sound like a growth business, the cash cow of the photo business funds a healthy dividend and a continued rollout of the automated laundry business, which is highly profitable and has plenty of room for growth. The overall result is a growing, quality business with a high yield.

While we look for unrecognised quality, we also look for growth that has yet to be priced in. Growth and income can often be uneasy bedfellows, with high growth requiring capital investment rather than the distribution of income. One company delivering both is the pan-Asian bank Standard Chartered (LSE: STAN). The company has had a volatile history, but it has been reshaped in recent years.

Sub-scale retail businesses have been removed, while the board has refocused on the Asian commercial bank and a rapidly growing wealth franchise. Standard Chartered Bank expects to deliver annual top-line growth of 7% over the next few years, but the highest-quality part – wealth – grew 30% last quarter. The bank also distributes a high proportion of its profits to shareholders.

Our portfolio is overweight energy. We like the cash-generative nature of the sector. We can accept highly cyclical returns, but we do want to own firms able to pay dividends even in the lows of the cycle. Energean (LSE: ENOG) is one I like. It sells gas on fixed-price contracts linked to inflation, supporting a resilient 10% dividend yield. It also has an entrepreneurial management team with a record of creating significant value.

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