- Investors seeking income from dividends often have to choose between a sustainable income, a growing income or a high income
- Targeting high income alone risks over-concentration in certain sectors
- It is possible to achieve all three, but a broader approach is needed
In today’s stock markets, it may be possible to get a sustainable income, a growing income or a high income, but it is rare to find a combination of all three. High income often comes with greater risk of dividend cuts, while achieving income growth often means starting at a lower point. However, there are options for those willing to approach the problem a little differently.
In the current environment it is relatively easy to get income, but it is growth in income that is elusive. While dividend growth has been superficially good in 2017 it was relatively narrowly based and depended heavily on large exchange rate gains. Taking out currency effects, underlying dividends fell marginally (1.). As inflationary pressures mount, investors need their income to keep pace with the rising cost of living.
Trying to generate an income of, say, 5% from company dividends alone risks limiting investors to those parts of the market with fewer growth prospects, or where there is an element of distress. In general, strong companies with the potential to grow both their payouts and their share price are paying lower levels of dividends.
There is also the problem of concentration. UK dividends have tended to come from a relatively small range of companies. According to the most recent Capita Asset Dividend Survey (1.), 56% of the overall dividends from the UK market came from just five companies (Royal Dutch Shell, AstraZeneca, BP, Glaxosmithkline and Vodafone). This is inherently risky. In chasing higher yields, investors are limiting their investment opportunities.
Is there an alternative option? In addition to its portfolio of dividend-paying shares, the Shires Income Trust uses three tools to raise the income it aims to pays to shareholders and, importantly, to try to ensure that income grows over time: To target a higher overall income, the trust holds a portfolio of preference shares. Preference shares have ‘preference’ over ordinary shares for payment of dividends and return of capital in the event of a company’s insolvency. They tend to pay higher dividends than ordinary shares and the dividend is fixed, rather than being set by the company’s management team every year.
Preference shares sit somewhere between equities and bonds in terms of risk. The Shires Income portfolio of preference shares paid an average income of around 6% (as 30 April 2017).
We also aim to boost the yield with the use of leverage. This involves borrowing money to invest in the hope that the return from the investments will exceed the cost of borrowing. It can be risky to do this on a stock market portfolio, where capital values can bounce around. As a result, we use leverage in the portfolio to buy preference shares, where the income should be more predictable. The trust has around 20% leverage (as at 3 April 2017), which may also help boost the overall yield.
Selling options on our portfolio of shares is another way to boost the income. These options give the buyer the right (but not the obligation) to buy the shares at a certain price (the ‘strike’ price) at a certain time. For this, we receive a small payment that we add to the income we distribute to shareholders in the trust. If the shares are above the strike price, the option will be exercised and we have to sell our shares. The risk, in this case, is that we miss out on any further upside in the shares. If the shares are lower, the option will not be exercised and we keep the shares.
Using these tools gives us more flexibility on the way we invest the equity portion of the portfolio. For example, we have around 15% in smaller companies. Smaller companies with faster growth may be in a position to grow their dividends more quickly. Elsewhere in the portfolio, we even have companies that have no starting income, but where we believe that growth will be rapid and dividends may be paid in future.
Having said that, we aim to ensure that the core of our portfolio is in well-managed, high quality companies. In common with the majority of fund managers at Aberdeen, we look for companies with a sound business model, a strong balance sheet, with good, transparent cash flow. Dividend payments tend to be the result of having a robust business, where profits are quickly converted to cash.
In blending these different strands within one portfolio, we believe that we can – at least partially – solve the income conundrum, seeking to achieve a higher, stable income with the ability to grow over time.
RISK WARNING
The value of investments and the income from them can fall and you may get back less than the amount invested. The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV. Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends. The Company can use derivatives in order to meet its investment objectives or to protect from price and currency movements. This may result in gains or losses that are greater than the original amount invested.
Please remember that past performance is not a guide to future results.
FTSE International Limited (‘FTSE’) © FTSE 2017. ‘FTSE®’ is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. RAFI® is a registered trademark of Research Affiliates, LLC. All rights in the FTSE indices and/ or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.
This article is issued by Aberdeen Asset Managers Limited (company registration no. 108419), 10 Queen’s Terrace, Aberdeen AB10 1YG. Aberdeen Asset Managers Limited is authorised and regulated by the Financial Conduct Authority in the UK.
Find out more at –
