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The UK equity income trusts poised for a Brexit bounce

The UK equity income trusts poised for a Brexit bounce

Don’t let the Brexit shambles get you down. If you’re wondering where to invest this year’s ISA there is a compelling argument to deploy your cash in the UK stock market and, more specifically, in the UK Equity Income investment trust sector where a number of strong long-term performing funds can be found.

The UK stock market is attractive is because it’s cheap compared to other major markets and that’s important because buying low and selling high is the way to make money. Of course the political crisis caused by our decision to leave the European Union has hurt the UK economy as companies delay investment and spending decisions amid the uncertainty of our Brexit preparations. The Office for Budget Responsibility confirmed that last week by cutting its already paltry forecast for economic growth this year to 1.2% from 1.6%.

The important point for ISA investors, however, is that the UK stock market has little to do with the UK economy. Companies listed on the London Stock Exchange generated just 27% of their revenues from the UK last year, according to fund manager Schroders, with the rest derived overseas.

Investor flight

Nevertheless, the UK stock market has been marked down as overseas investors in particular, discouraged by the fall in the pound since the 2016 referendum, have viewed the UK as un-investable. British investors have also fled pulling £11 billion from open-ended funds investing in the UK.

Despite this the FTSE All-Share index has done rather well, rising around 25% since the Brexit vote although the gain looks poor against the 37% advance in the US stock market, for example. However, the investor exodus has left the UK stock market trading 30% below global stock markets on a variety of valuation measures, close to a 30-year low.

‘It is difficult to avoid the conclusion that the UK is cheap at present,’ said Simon Elliott (pictured), investment trust analyst at Winterflood Securities.

The extent of the undervaluation is best shown by looking at the yield from dividends paid by FTSE companies. Dividend yields move in the opposite direction of share prices so a rising yield shows a stock or index has fallen (providing the dividend hasn’t been cut).

The All-Share currently yields 4.4%, down from 4.8% at the end of December, which reflects the 9% rebound in the index this year which makes up for most of last year’s fall. That is still significantly higher than its 3.5% average yield of the past 30 years, which shows how far UK shares have not kept pace with rising corporate profits. (Ironically, Brexit has boosted overseas company earnings in the past two-and-a-half years as they are worth more when converted into the weak pound.)

As a result over 30% of medium-sized and large FTSE companies yield over 5%, providing a large pool of potential investments for UK equity income funds looking to deliver capital growth and rising income for investors.

Crisis pricing

But isn’t there a danger that the UK stock market could fall further? Sue Noffke (pictured), manager of Schroder Income Growth (SCF), a £190 million UK equity income investment trust, told journalists last week that was possible but believed investors should take comfort at investing at the market’s current valuation.

According to Noffke, UK dividends would have to fall by 25% or the UK stock market rise 35% – ‘or a combination’ of both – for the All-Share’s yield to return to its long-term average. Given that UK dividends declined only 15% in the 2008/09 financial crisis, she views the former scenario as unlikely and underlines her confidence in the UK market’s prospects.

‘Brexit is a local problem not a global problem,’ she said comparing the UK’s current difficulties with the worldwide recession caused by the near collapse of the banking system a decade ago.

Simon Gergel, manager of Merchants (MRCH), a rival £526 million equity income trust, agreed. ‘I’m not too pessimistic on either scenario,’ he said in reference to either a no-deal or agreed EU withdrawal.

‘In the end it won’t have been the disaster some people have led us to believe. It is a political judgement and depends in part on what the authorities do,’ said Gergel (pictured) who anticipated the Bank of England would take steps to support the economy and the financial system if a hard Brexit threatened serious harm.

UK Equity Income Trusts' Brexit exposure

Trusts with higher holdings in mid and small-cap stocks (see bottom half of 'mid/small cap & AIM' column may benefit from a 'soft' Brexit, those with less (and more in bigger, international stocks) may gain from a 'hard' Brexit, but levels of gearing (borrowing) and investment style (see midle columns) will also influence how much they participate in any stock market rally, according to broker Winterfloods.

Trust Mid/Small Cap & AIM stocks % Style Borrowing (gearing) % Dividend yield % Share price premium (- discount) to net asset value %
Finsbury Growth & Income (FGT) 11.39 Growth 2 2 1.4
City of London (CTY) 14.58 Core 11 4.4 0.9
JPMorgan Claverhouse (JCH) 16.7 Core 9 2 3.9
Schroder Income Growth (SCF) 20.08 Value 10 4.2 -6.2
JPMorgan Elect Managed Income (JPEI) 20.13 Value 0 4.5 -4.7
BlackRock Income & Growth (BRIG) 20.29 Core 2 3.7 -5.4
Invesco Income Growth (IVI) 26.24 Core 3 4.3 -14.4
Troy Income & Growth (TIGT) 27.59 Core 0 3.5 1.1
Value and Income (VIN) 28.72 Core 29 4.4 -20.8
Shires Income (SHRS) 29.24 Core 22 5 1.7
Dunedin Income Growth (DIG) 30.93 Growth 17 5.3 -9.8
Murray Income (MUT) 31.16 Core 7 4.3 -6.8
Merchants (MRCH) 33.02 Value 18 5.3 -2.2
Temple Bar (TMPL) 40 Value 9 3.6 -2.2
BMO UK High Income (BHI) 41 Core 5 5.5 -9.7
Edinburgh (EDIN) 46.3 Core 7 4.3 -7.6
BMO Capital & Income (BCI) 48.81 Core 5 3.6 -1.6
Perpetual Income & Growth (PLI) 52.09 Core 12 4.4 -11.8
Lowland (LWI) 58.46 Value/core 12 4 -5.5
Aberdeen Standard Equity Income (ASEI) 69.42 Value 13 4.7 -2.3
Diverse Income Trust (DIVI) 70.85 Core 0 3.8 -1.4

Source: Winterflood Investment Trusts. Mid/Small Cap & AIM stocks data 31/1/19. Rest 15/3/19.

(article continues) Despite the pummelling of the UK stock market, ratings of UK investment trusts have held steady. Shares in these funds listed on the London Stock Exchange have traded at an average discount of 3.7% below their net asset value since the referendum and remain there. In other words they are not cheap but still worth pursuing as their record is very good, generating an average total return to shareholders of 292% in the past 10 years. This compares to 199% from the FTSE All-Share, according to the Association of Investment Companies (AIC).

The sector is home to 11 of the 20 AIC ‘dividend heroes’ or investment trusts that have grown annual dividends for 20 or more consecutive years, most notably City of London (CTY), a £1.5 billion trust run by Job Curtis at Janus Henderson, which along with two global trusts, has increased shareholder pay-outs for a record 52 years and yields 4.4%.

Investors still don’t know how Brexit will pan out. Elliott of Winterflood said a ‘good’ Brexit involving a deal and avoiding disruption to trade would see the pound continue this year’s rally. This would benefit equity income trusts with larger amounts invested in UK-facing medium-sized and smaller companies whose shares have been punished by Brexit fears, such as Diverse Income Trust (DIVI), a 3.8% yielder run by Gervais Williams and Martin Turner at Miton Group.

Alternatively, a ‘hard’ Brexit with the UK crashing out of the EU without a deal would see sterling plunge. That would benefit trusts invested in more international companies with greater overseas earnings such as the sector’s top performer Finsbury Growth & Income (FGT), run by Nick Train.

In addition, to the small-mid-cap stock factor, Elliott said the investment style of a trust was important. In the past 10 years ‘growth’ funds like Finsbury Growth willing to pay up for high quality companies have done well. In future it’s possible ‘value’ funds, which look to buy cheap, unloved and not so fast-growing companies, could do better as interest rates rise. Noffke’s Schroder Income Growth and Gergel’s Merchants, which offer dividend yields of 4.2% and 5.3%, are both value funds.

Safety option

As a safety option, Elliott recommended Troy Income & Growth (TIGT), a £216 million trust run by Francis Brooke and Hugo Ure at Troy Asset Management. It invests in blue chip FTSE 100 stocks, yields 3.5% and has a policy of avoiding a discount on its shares. ‘This may mean it does not fully participate in any “Brexit bounce”, but it will offer protection in the event of a shock,’ Elliott said.

Elliott also picked Perpetual Income & Growth (PLI), a Winterflood broking client, as a potential recovery play. The £766 million trust has suffered from a slump in fund manager Mark Barnett’s form and high weighting to smaller companies and its shares trail on a near 12% discount. ‘If its performance does improve, we could see it being re-rated and believe that its dividend yield of 4.4% is attractive, particularly given its record of 5.9% per annum growth over the last 10 years.’

A shorter version of this article was published in this weekend's Telegraph.


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