Interest rates have plummeted. Bond yields have collapsed to historic lows. Accordingly, in the pursuit of income, UK investors have sought refuge in equities, despite their higher volatility … but all too often have been seduced by yields which are inflated simply as a consequence of depressed capital values. This piece explains how to exercise care when selecting stocks in the current climate in order to avoid falling into the ‘yield trap’.
Escaping the illusion of yield
Things have changed. In the past, one suspects that most wealth managers would have based their approach to long-term investment portfolio construction on Modern Portfolio Theory, as espoused by Nobel prize-winning economist Harry Markowitz. In essence, the theory asserts that investment gain cannot be achieved without risk, but that risk can be confined broadly within pre-ordained limits through judicious asset diversification. At its simplest, investment gains – and therefore risks – reside primarily within the portfolio's equity component whilst the confinement (and traditionally the main source of income) is the key preserve of the bond component. For as long as most of us can remember, the industry's answer to fulfilling the needs of those seeking a low-risk secure income was often a portfolio of high-quality bonds; such a portfolio could be relied on to provide a 'natural' income from interest receipts that kept pace with, or ideally exceeded, inflation.
That was then and this is now. Interest rates have plummeted. In March 2009, the Bank of England cut the UK base rate to 0.5%, the lowest level since it was founded in 1694, cutting it again to 0.25% after the EU referendum. During a special meeting of the Bank's Monetary Policy Committee in March 2020, and on the well-founded presupposition that the COVID-19 pandemic would result in a "sharp and large" economic shock, it decided to cut the rate further still, to its current level of 0.1%. Inflation has admittedly also fallen in recent years, but not sufficiently to offset the fall in interest rates. Unsurprisingly, bond yields have collapsed to historic lows, with investors understandably spooked by the coronavirus seeking safety in paying higher prices for declining yields. As a result, many assets with attractive income have been bid unsustainably because of yield demand. In December, Bloomberg confirmed that the total outstanding value of negative-yielding bonds had swelled to a record $18 trillion globally, representing 27% of the world's investment grade debt.1
Equity investors will be more than aware that the primary appeal of corporate stock is that it delivers two valuable elements of return: capital and income. Often, however, the two are conflated – a commonplace error prompted by the reality that capital volatility masks income stability. Consider the UK market, as represented by its two key indices: the FTSE All-Share and FTSE 100. In the 30 discrete years since 1991, they both returned a capital gain in 20 of those years2, whereas they both, needless to say, delivered a positive income return in 100% of the years. It's arguably a simplistic point, but worth remembering nonetheless: whilst there may not have been capital gains in any particular year, an income was always paid. The uniquely challenging environment of recent months has mandated a large degree of fresh thinking and compelled investors – even the more seasoned amongst us – to revisit a host of long-held assumptions. Inevitably, in seeing their traditional sources of income, such as bank deposits and gilts, undermined – UK investors have sought refuge in equities, despite their higher volatility. However, in so doing, many have found themselves lured into the all too beguiling 'yield trap', whereby headline yields are inflated simply as a consequence of depressed capital values.
Listed UK businesses paid circa £110 billion in dividends in 2019 but this fell to £62 billion in 2020, a fall of 44%; this compares to a decline of circa 20% globally as a result of the general financial crisis in 2008. Despite this pervasive corporate dividend-cutting and suspensions, the forecast yield for the UK stock market for the next 12 months is 2.8% to 3.1%, which is still at a healthy premium to the yield on most other global equity indices.3 By way of comparison, the current yield on the US S&P 500 Index is 1.61% – less than half that anticipated for the UK.4 In part, this is explained by US corporates adopting a different approach towards returning capital, generally favouring buybacks. Notwithstanding the superficial attraction of the UK yield figure, it pays to delve deeper since the widespread recent popularity of dividends has entrenched a number of misconceptions, chief amongst which is that a high yield is invariably a good thing: too heavy a focus on that yield runs the risk that the sustainability of the underlying dividends – let alone the prospects for growth – are overlooked.
In 2019, the London Stock Exchange ran a simple analysis, the results of which are shown in the table below. It calculated the outcome of investing in the 10 highest-yielding shares in the FTSE 100 five, 10 and 15 years ago on a total return basis. Even with the inclusion of dividend income for those 10 stocks, the index itself fared better over all three timeframes, a function of the capital performance of the selected stocks.5
Source: London Stock Exchange, as at 31.05.19
A parallel concern is the concentration of dividend payments amongst UK listed companies, which has long been a potential source of risk. Indeed, following the slew of dividend cuts announced in Q2 and Q3 2020, the situation has markedly worsened. According to data from AJ Bell, 53 current or former members of the FTSE 100 have cut, deferred or cancelled over £37 billion of dividend payments in 2020. Most notably, in late March, the Prudential Regulation Authority declared that the big five FTSE 100 banks should not pay dividends or run any share buyback programmes in 2020 (it has now relented, allowing Barclays, HSBC, Lloyds and Standard Chartered to return cash to shareholders in 2021). Just 10 firms are responsible for circa £32 billion in dividends in 2020, over 50% of the total; the top 20 are forecast to generate circa three quarters of the index's total payout.6
Yield is, of course, inversely correlated with price. This, and most other measures, such as price to book values (PBV) or price/earnings (PE) multiples, indicate that the UK market currently represents good value – indeed, relative to global equities, it has not been cheaper for decades. However, for this not to remain a fact of purely academic interest – and for the yield trap to be avoided – something fundamental needs to change in order to release that pent-up value. In the view of many, the recent resolution of a Brexit deal and the arrival of a number of highly effective COVID-19 vaccines may go a large way towards providing the necessary impetus as investors become more confident in the prospects for UK stocks.
All of these issues, and more, have been very much front of mind for James Henderson and Laura Foll, who jointly manage Henderson Opportunities Trust, a UK-focused investment trust within the Janus Henderson stable. The trust has an all-cap UK equity mandate, although it retains a distinct bias towards smaller, early-stage companies that hold significant growth potential, and a value-tilted investment style focusing on out of favour or under-researched companies that are attractively priced. The trust has powered to the top of the Association of Investment Companies’ UK All Companies sector, with an NAV total return of c 40% in the second half of 2020.8 Whilst income is a secondary objective, dividend growth over time is not unimportant in that quest for superior, long-term overall returns, and performance, on a total return basis, has been strong with the trust exceeding its FTSE All-Share benchmark over one, three, five and 10 years on both a share price and net asset value (NAV) basis.7
Many of the trust’s underlying holdings pay dividends, and the dividend over the last five complete financial years has increased by a compound annual growth rate of 15.8%.9 (Since the beginning of the 2020 financial year – 1st November 2019 – dividends have been paid quarterly.) Taking into account those dividends, as the chart below illustrates, a £10,000 investment in the trust would have grown to £32,396 over the last 10 years, whilst its All-Share benchmark would only have grown to £17,141.10
Source: Janus Henderson, as at January 2021
Looking at the dividend return discreetly, an investor buying £10,000 of Henderson Opportunities shares 10 years ago, at the beginning of 2011, would have received £858 of dividend income in 2020 – i.e. a 'yield on cost' of 8.58% – compared to £489 of income if they had invested the same amount in the All-Share benchmark.11
The all-cap focus gives the trust the flexibility to pursue faster-growing small and mid-cap companies, which make up more than 70% of the portfolio, while potentially limiting volatility through holding larger £1bn+ companies (currently circa 15%). Although the benchmark is an all-cap UK index, the trust’s portfolio differs significantly from the index, which is much more heavily weighted towards large cap stocks, thus performance is also expected to diverge from the benchmark.12
Performance has benefited from holding a number of what the managers refer to as 'next-generation leaders' in the UK. As bottom-up stock pickers, both Laura and James continue to see good value opportunities across the UK market, particularly on AIM, and say their intention to maintain gearing at a 'decent' level (circa 10-15%) is indicative of feeling the portfolio and market offer good value.
They are keen to make the point that the world has changed, with the prospects for some businesses permanently impaired, and the pandemic accelerating existing structural pressures in some industries. Prior to COVID-19, high street retailers were already experiencing intense pressure from e-commerce, integrated oil companies were already treading a fine line as they attempt to shift their assets towards renewable energy, and banks were attempting to ride out a prolonged low interest rate environment, pressuring margins. Furthermore, In the context of dividends specifically, there are approximately 250 listed dividend-paying businesses in the UK (on the main market), not an extensive universe for an active stock picker, and some of those are in structurally challenged industries and/or were over-distributing capital through excessive dividends – hence the need to exercise particular care when selecting stocks in the current climate.
In a post COVID-19 world, some companies will inevitably struggle to restore their earnings or dividend payments to pre-pandemic levels. In this context, investing in a diverse portfolio of well-managed, market-leading businesses is of heightened importance, something that Henderson Opportunities Trust aims to achieve via exposure to a broad range of end markets, many with structural growth tailwinds such as alternative energy.
1Source: Bloomberg, 10.12.20
2Calendar years 1991 to 2020 inclusive
3Source: Link Group UK Dividend Monitor, Issue 44, Q4 2020
4Source: Wall Street Journal Markets, 24.12.20
6Source: AJ Bell Dividend Dashboard, Q4 2020
7Source: Morningstar, to 30.11.20
8Source: Edison Investment Research, to 11.01.21
10Source: Janus Henderson, to January 2021
11Source: Janus Henderson, 01.01.11 to 31.12.20, weighted average trailing 12 months dividend yield re FTSE All-Share
12Source: Henderson Opportunities Trust PLC, Annual Report 2020
All performance, cumulative growth and annual growth data is sourced from Morningstar as of 31.03.2021
Diversification: A way of spreading risk by mixing different types of assets/asset classes in a portfolio. It is based on the assumption that the prices of the different assets will behave differently in a given scenario. Assets with low correlation should provide the most diversification.
Yield: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment
Price-to-book (P/B) ratio: A financial ratio that is calculated by dividing a company’s market value (share price) by the book value of its equity (value of the company's assets on its balance sheet). A P/B value <1 can indicate a potentially undervalued company or a declining business. The higher the P/B ratio, the higher the premium the market is willing to pay for the company above the book (balance sheet) value of its assets.
Price-to-earnings (P/E) ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.
Value investing: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favoured techniques is to buy companies with low price to earnings (P/E) ratios.
Small and mid-cap stocks: The terms small, medium and large cap stocks, indicate how valuable the stocks are in regard to market capitalisation. In the UK large caps are generally considered to be those that are listed in the FTSE 100 index. Mid-cap companies are generally considered to be those listed on the FTSE 250, which ranges from a market cap of approximately £4 billion down to £500 million. The FTSE Small Cap index includes stocks worth as little as £150 million.
Net asset value (NAV): The total value of a fund's assets less its liabilities.