In investors’ hunt for income, it’s easy to get seduced by some of the high yields available in the FTSE 100. But firms that can compound their dividends over time can help investors gain sufficient diversification in their income portfolios.
Shell (RDSB), BP (BP.) and HSBC (HSBA) all yield above 5% and are the biggest contributors to the UK blue-chip index’s income. However, their contribution adds up to 25% of the FTSE 100’s 4% yield, with the top 10 dividend payers accounting for half the income produced by the index.
“That’s a very high level of concentration,” says Hugo Ure, investment manager at Troy Asset Management. Investors should be less exposed to those names and, instead, “have a more diversified dividend-generating base”.
Ure’s Morningstar Silver Rated Troy Income & Growth Investment Trust (TIGT) owns oil giants BP and Shell, but not HSBC. The portfolio currently has five of the 10 biggest FTSE 100 income contributors in its top 10 holdings.
But the trust likes to look for compounders, and also counts Compass Group (CPG), Experian (EXPN) and Nestle (NESN) in its top 10. Some of these compounders are obvious, Ure says, like Unilever (ULVR) and British American Tobacco (BATS). But others not so much.
Below, Ure picks out three examples for Morningstar.co.uk, two of which are high-street stalwarts – not an area he, or many of his peers, are particularly positive about. “We’re not bullish on the UK high street – we are quite consensus in the view that it’s a challenged environment,” he explains.
However, these two stocks have high-quality management teams that are able to navigate that difficult environment. “Both of them have very strong capital allocation and recognise that solely pushing harder on the revenue line against a headwind is not a constructive use of capital.”
WH Smith (SMWH)
WH Smith is a firm that is, on the face of it, very much struggling against these headwinds facing retailers. Over the past three years, revenue from its high-street stores has declined by 16% to £610 million.
However, thanks to strict cost-savings, the retail business has managed to increase profits by 10% in the same period, to £62 million.
And the firm hit a milestone in 2017, with revenues from its travel business eclipsing those from high-street for the first time. In the past five years, its railway and airline outlets have grown revenue and profit by 35% to £624 million and 45% to £96 million respectively.
The most salient point, though, is that the ordinary dividend has grown 57% in the space of those five years. And that’s excluding the share buybacks and special dividends. In total, since 2007 the firm has returned almost £1 billion to shareholders.
Ure says chief executive Steve Davies tells him those costs savings continue to be in the financial model for the next two or three years, “so there’s nothing on the horizon that suggests that’s going to dry up”.
It continues to grow its travel business, with Thursday’s trading update ahead of preliminary results for the 12 months to 31 August, noting it had opened eight stores in Terminal 4 of Madrid Airport in August, plus it had opened its first in Rio de Janeiro. Those take it to 286 stores in international airports.
“There’s no limitation on that growth for the moment,” says Ure. “I think this is a story that has been run really well both by Steve Clarke and by his predecessor Kate Swann and it can continue.”
The firm currently trades on around 20 times 2017’s earnings, though in the year-to-date has been as cheap as 18 times. Should the full-year dividend once again grow by 10%, as expected, the firm current trades on a forward yield of 2.55%.
Next has also evolved well over the years and exhibits similar traits to WH Smith. Despite being best known for its estate of high street stores, its online business, which used to be known as Next Directory, continues to flourish.
Revenue and profits in its Retail business have fallen over the past five years by 5% to £2.1 billion and 23% to £269 million respectively. But its online business’s revenue and profit have increased by 41% to £1.88 billion and 29% to £460 million respectively.
But it’s been a multi-year evolution for the online business, first through mail-order and catalogues before transitioning over to internet shopping. “That means they have a very long heritage in dealing with the distribution side of it, which is increasingly important,” says Ure.
While WH Smith is attractive for its convenience aspects – its products don’t tend to be planned purchases – Next is a unique offering. It’s not obviously a stock Ure would be attracted to: “We would be very reluctant to be invested in the Debenhams of this world – those big high street chains with long lease lengths.”
But, again, Next is another dividend compounder. Its payout has grown by 22% over the past five years to 158p in 2018. It yields 2.86% and trades on a fairly low price/earnings ratio of 13 times. Next also pays special dividends.
While Ure doesn’t expect to see a return of buzzing high streets any time soon, he certainly doesn’t rule out a recovery in the sector, which is not priced into the valuations of either Next, nor WH Smith.
“We have had opportunities to buy both WH Smith and Next for various reasons at relatively low multiples. If you look at the pure inline or tech stocks, those multiples have not been available for some time.”
LondonMetric Property (LMP)
The final stock is LondonMetric Property, which is a slightly different play on retail. It is a real estate investment trust that owns and rents out retail parks and convenience stores as well as distribution centres.
While it does own some leisure and residential buildings, the firm is increasingly concentrating its portfolio around logistics distribution and helping retailers fulfil online orders. As a result, it is benefiting from that growth in online shopping.
Reported profit has increased almost 50% over the past five years, with the dividend per share more than doubling to 7.9p, giving a yield to today’s share price of 4.3%.
Since Troy took over the running of the trust in August 2009, it has trebled investors’ cash, turning a £10,000 investment into just shy of £30,000. The FTSE All Share in that time is up just 143%.
Most importantly, it has grown the dividend in every year that Troy has managed the trust. Since 2010’s full-year results, the payout has grown by 42% to 2.56p last year, giving a yield of 3.3%. Last year’s dividend was covered 1.5 times by earnings.
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