Hear from the fund manager, David Smith, hosted by ShareSoc

Good morning and welcome to this Sharesoc webinar with Henderson High Income Trust.

My name is Vijay Tohani and I’m a director at Sharesoc and I will be your host for this event.

Today’s presenter will be David Smith, who is the, is, is the portfolio manager at the Global Equity Income team at Janus Henderson Investor.

Without further ado, it gives me great pleasure to welcome David Smith.

Over to you, David.

Thank, thank you, Vijay.

I’ll, So, so it looks like obviously 50% of you know about the trust, own the trust, 50% of you don’t.

So if I share my screen, I will then can talk through, talk through my presentation and actually the presentation probably is geared up for that.

So the first half is very much an introduction to the trust and what it does, how we produce our, our income, our dividend for shareholders.

And then the second half really talks a bit more about, you know, what we’re seeing in terms of outlook for markets, you know, where we’re seeing opportunities as well.

And I suppose I’ll just start by saying, you know, Henderson High Income, you know, it doesn’t take a genius to guess what, what it kind of does really, ’cause the name is right there.

You know, it’s there to provide a high level of income, but also the prospects of capital growth, into the longer term.

Now, I’ve been involved in the trust since 2012, and it is very much, you know, the majority of the assets are UK equities, so investing in both large and mid and small cap companies across the UK market.

But our key differentiator is our ability to own bonds, and I’ll obviously talk through that in more detail as I go through the presentation.

So I guess the, the, the first slide, why would you pick Henderson High Income?

Well, the chart on the left kind of shows you that.

You know, we deliver that high income.

So if you’re looking for a, you know, a good level of dividend that’s been sustainable over the longer term, that’s grown, you know, that’s something that we provide and it yields a lot more than all those other asset classes in the chart there.

So firstly, more than the FTSE All-Share, more than what you can currently get in a savings account, but also yielding more than the UK 10-year gilt.

Now, obviously this is as of the end of July and gilt yields keep moving up, but I think we still have a slight yield premium over the 10-year gilt yield even if it’s moved higher, so 5.4% dividend yield as well.

And what I say is we do it in a much more diversified way.

So, you know, one of the main criticisms of the UK market is it’s overly concentrated for income.

So you can see that on the chart on the right-hand side, where the top 20 dividend payers in the FTSE 100 contribute 70% of the market income.

Now, as an active manager, we can construct a much more diversified portfolio.

Obviously, having the bonds also helps in that regard.

So actually those top 20 companies only contribute around a third of our income needs as well.

So that’s important that if you go through more difficult times where certainly some of those big companies maybe come under pressure in terms of their dividend paying ability, you know, you think back to COVID where the banks had to cut their dividends to zero because the regulator told them.

You know, think BP back in 2010 because of the Macondo situation there as well.

So, you know, having too much concentration is obviously bad for your income needs.

So actually having a well-diversified portfolio, not being over-reliant on any one company, stock, or sector actually is quite good in terms of making sure you’ve got that diversity of income going forward.

That was very much a very brief overview.

Let’s delve into a bit more detail in terms of the trust.

You know, as I said, it is a UK equity income trust, but our key differentiator is the bonds.

We think it’s well established.

It was launched back in 1989, and it’s grown to about £440 million of gross assets as well.

We are very much bottom-up stock pickers, so really doing the detailed analysis of the companies that we’re going to invest in, but we do have that strong valuation discipline.

You know, we’re not going to overpay for the qualities we see within a company.

It’s not just about dividend yield.

We’re also focused on dividend growth as well, and again, I’ll come into the importance of that in a little bit as well.

In terms of management fee, that’s actually come down in the last couple of years, so, you know, that independent board of directors really looking after shareholders and making sure the fee remains competitive.

So it’s come down to 0.45% of net assets per annum going forward as well.

As I said, it’s not just about dividend yield.

It’s also about dividend growth.

And one of the things that I was tasked to do when I first came onto the trust in 2012 was kind of reposition the equity portfolio so you could generate a sustainable growing dividend as well.

Now, it’s important to mention that, you know, currently there is a trend towards companies or investment trusts paying out dividends and income out of their capital.

Actually, we’re very much of the view that income, wherever possible, should come out of earned revenues from the trust.

So, you know, we generally have a covered dividend in most years and, you know, clearly during COVID where we saw big cuts, we couldn’t obviously cover our dividends in 2020 and 2021.

But given we’re an investment trust, we utilised our revenue reserves to be able to continue to pay and grow our dividends through that period.

Now, it’s safe to say over the past 13 years of that dividend growth track record, we’ve actually covered the dividends in 11 of those years as well going forward.

So not just about high yield.

We’ve also grown the dividend every year for the last 13 years by a compound average growth rate of about 2.1% there as well.

One thing you need to, if you’re going to invest in Henderson High Income, you need to be comfortable in, is a level of gearing within the trust.

So, you know, 18.7% where we are at the end of July can seem relatively high versus some of the peer group in the UK equity income sector.

But actually what I always say is, you know, there is an element of structural gearing.

What I mean by that is it’s leaning into our unique structure of being able to own bonds.

So effectively the majority of the bond portfolio is funded by the gearing.

So that structural gearing, you know, bonds are typically less volatile than equities, so they do lend themselves better to being funded through that gearing.

You know, what’s the other role of the bond portfolio?

You know, to provide that resilient income.

So, you know, when we do go into more difficult times, companies will typically prioritise paying their coupons to bondholders over dividends to equity holders.

So in times of stress, it does provide a resilience of income stream.

Offers diversification.

You know, I kind of talked about that before within the FTSE 100 as well.

So get a different source from equities to get our income as well.

As I said, it kind of enhances our dividends.

So where we can currently borrow at a cheap rate, a borrowing cost, so we have long-term fixed-rate borrowings of 3.67%, invest that in a broadly stable portfolio of bond holdings that currently yield around 5.5% to 6%.

That’s a good way of generating that extra income for the trust and it’s really why the yield is so much higher than, say, the FTSE All-Share there as well.

And the last point about the bond portfolio, it really helps dampen down the overall volatility of the trust.

And you can kind of see that on the chart on the right-hand side there.

This just tracks the volatility of the NAV of Henderson High Income versus the FTSE All-Share.

And what I would say is despite the relatively high level of gearing at 18.7%, actually because we balance that gearing with the low volatility of the bond portfolio, actually the volatility of the overall trust has been more in line with the underlying UK equity market as well, despite that level of gearing.

So as you need to, you know, just going back to that structural gearing, it’s always going to be there.

You need to get comfort on that to invest in Henderson High Income.

But like I said, the majority of that gearing is backed by a more stable bond portfolio, and when you strip out that element of gearing towards the bonds, the actual gearing towards equities is around about 6.9%, so just under 7% at the moment, which is much more in line with the wider AIC UK equity income sector there as well.

As Vijay mentioned, I work within the Global Equity Income team.

So quite a diverse, broad mix of experiences there.

You know, we run about £14 billion of assets, and I would say about half is global income and half is UK income as well, and there’s obviously some stalwarts of the investment trust world that sit on our team, whether that’s Job Curtis, who runs City of London, James and Laura who obviously run Lowland and Law Debenture, and myself and other colleagues as well.

But it’s a real mix of experience, as I said, which brings different aspects of how we think about stocks and the resources we have available to us.

Now, it’s not just our team at Janus Henderson. We are a large global company, and we utilise expertise outside the team as well, not least some of the global analysts we have that certainly help look at some of the larger names that we hold within the portfolio and do deep dives and modelling that we can utilise to help us think about where the financials move within a company as well.

The stock selection process, you know, what attracts us to businesses, what we look for, this is kind of a real summary of that.

And I kind of always break down the investment process into three main parts.

Firstly, the fundamentals.

You know, really getting to grips with what is a company’s key attributes.

And I think the things that we’re trying to look for are, A, a robust business model.

So companies and business models that are going to, you know, last the test of time.

And we want companies that we understand the business models, we understand how they generate profits, et cetera.

And as I said, you know, things that are likely to be around and survive over the longer term.

And I think that’s incredibly important, especially in this day and age, where the advancements in technology are so much that there is this debate in the market currently about AI and how it impacts businesses and how it could disrupt and disintermediate certain companies, et cetera.

So it’s thoroughly important to us that we find companies that do have that robust business model.

And then it’s about looking at high and defendable barriers to entry.

You know, making sure our companies, again, are protected against whether that’s traditional competition or whether that’s protected against new entries to market through those new technologies that have been developed on a seemingly daily basis.

And then finally kind of understanding, you know, the companies and the management teams that run the businesses that we’re going to invest in.

You know, it’s very important, I think, in this day and age to have proven management teams that can deliver on the strategy that effectively we’re buying into to own a company.

And that has been shown through COVID, making sure that when the world changes dramatically, have they got the capabilities to be able to navigate their company through what was a very difficult period.

Then we turn to financials.

You know, really understanding the sustainability of a company’s financials.

You know, how sustainable is that growth?

How does a company turn revenues into profits and ultimately cash flow?

Has it been investing enough in its own business to sustain that growth, to sustain the dividend, and ultimately be able to grow it into the longer term?

And then finally about understanding the balance sheet strength.

You know, it’s all very well when times are good, but invariably the next cycle will end and times will become tougher.

It’s making sure that we own companies that have got robust balance sheets that can survive those more difficult, more challenging periods in economies and markets really.

And then thirdly, the key thing that really underpins the whole process is valuation.

It’s all very well finding a good company with good fundamentals that has strong or improving financials.

It’s about being disciplined and not overpaying for those sorts of attributes.

So it’s about maintaining that valuation discipline within the stocks that you buy.

Now, I find these two charts quite fascinating and they need a little bit of explanation, so apologies for that.

But if you look at the chart on the left-hand side there, and this really comes down to why we focus on income sustainability, not just chasing the highest yielding areas of the UK stock market.

Because what the chart on the left-hand side shows you is actually the highest yielding areas of the market haven’t proven to be where you actually earn that dividend.

So what it shows you, the turquoise bars are what your forecast yield was.

So that’s what dividend yield you expected at different levels of dividend yield.

And what the blue bars show you is actually what you earned.

And as you can see, the higher the dividend yield, the less likely you are to actually earn that dividend.

And what we find historically is those companies that have a dividend yield between 2% and 4%, and 4% to 6%, actually produce the more secure dividends.

They’re the most sustainable.

They’re the dividends you actually receive.

Now, if you look at the chart on the right-hand side there, what’s interesting is that historically within the UK market, those same yield ranges, so that 2% to 4% and that 4% to 6% dividend yield range, have also produced the best total returns.

That’s because companies with those sorts of dividend characteristics are the best companies to balance not just dividend yield, but dividend growth.

So those companies in what we call the sweet spot, that yield between 2% and 4%, 4% and 6%, actually have the most sustainable dividends historically and have produced the best total returns historically.

And that’s why we search for companies typically within that sort of range as well.

Now, it would be amiss of me if I didn’t show you where we’re currently structured.

So this breaks down the equity portfolio as it currently is with those sort of dividend yield ranges there.

So as you can see, the vast majority of the portfolio is between that sort of 2% to 4% and that 4% to 6% dividend yield range.

Now, I’ve also colour coordinated the chart to show you the types of companies we like to invest in.

As I said, it’s all about diversification and it’s also diversification by sector, but also by the types of companies we invest in.

So the first group is really sort of compounders.

So what do I mean by a compounder?

Well, I think these are companies that produce stable growth.

So irrespective of what the economy is doing, effectively it should be able to produce good profit growth through a cycle.

And that means you’ve got that dividend growth certainty within a business like that.

And as you can see, a typical stock example there is Relx.

So this is a high-quality data business within the UK.

Again, it has grown quite attractively over the last few years and we think that growth can continue going forward.

The second group is quality cyclicals.

So what do I mean by quality cyclical?

Well, Genuit is a good example of this.

It’s market leading in what it does.

It provides plastic pipe into the building industry.

And it’s a quality company because it’s got a management team that, even though you’ve had a pretty harsh, difficult, lacklustre housing market, has still been able to grow profits in that market because of some of the structural growth drivers it’s seen within its business and because it’s quite good in terms of driving operational efficiencies out of its business to try and protect margins, even when the top line has come under pressure from a difficult end market.

So these are the types, yes, they’re cyclical businesses, but they can grow attractively when the wind’s in their sails, but actually they can still protect profits and your dividends when times are a bit more difficult.

The third group is defensive yield.

So your kind of high-yielding area of the markets that maybe produce a little bit less in terms of dividend growth, but it’s a secure dividend.

So the likes of utilities, for example.

Severn Trent, National Grid would fit into this bucket as well.

Maybe some of our tobacco names that we own, et cetera.

So these are big, really secure dividends that underpin the high level of dividend that we have within the portfolio.

And then the last group is really value opportunities.

So where we see really attractive valuations.

So British Land, the whole REIT sector, is an area of the market we’ve been adding to over the last twelve months where we see really good opportunities for capital growth.

British Land, Land Securities, they all trade at significant discounts to their NAV and that’s despite the fact that that NAV is actually starting to grow again.

Rents are starting to grow again.

Actually, the outlook, the earnings momentum and the profit delivery of the companies has been pretty good over the last twelve to twenty-four months, but yet the discounts haven’t narrowed yet, which we think will come eventually.

So that’s a very short whistle-stop tour of how we invest, how we think about things, the introduction to the trust, et cetera.

I’ll now come on to talk a bit more about how we’re seeing markets going forward.

And I think the first chart really on the left-hand side there is, you know, the UK market gets a bad reputation.

You know, people don’t think it performs well.

But actually, ever since interest rates started going up at the end of 2021, the UK market has done very well.

The FTSE All-Share has kept pace with the MSCI World ex UK despite not having any of those large US tech-based companies that have done incredibly well.

So despite that reputation, I always go back to the fact that you can still get a good return out of UK equities, and the last five years have kind of proved that.

But I would say if you move to the right-hand side chart, actually the performance of the UK stock market has been driven by quite a concentrated list of companies.

Now, what this chart does is split the FTSE 100 into two parts.

Firstly, the top 20 companies, the larger-cap companies in the FTSE 100.

Think oil and gas names, mining companies, banks, et cetera.

Those are the companies that have driven the returns in the UK stock market.

If you think about the bottom 80 companies within the FTSE 100 and the FTSE 250, so the medium-sized companies in the UK market, those have lagged quite materially.

And I think that’s quite interesting because then it kind of points you to what are the opportunities now, given the strength we’ve seen in the UK equity market?

What are the opportunities now?

And I think it’s probably outside that mega-cap area, so within the bottom 80 of the FTSE 100 and more towards those FTSE 250 mid-cap companies as well.

Now, inflation is a big worry for people at the moment currently given what’s going on in the Middle East and the impact it’s having on the oil price.

Well, what I would say, what we’re seeing in inflation is very different to 2022.

You know, inflation at that point, CPI rose all the way to double digits.

And what the chart shows you on the left-hand side there is that inflation was already above 6% before Russia invaded Ukraine.

So we already had an inflation problem at that point in time before we saw a big move in energy prices, oil prices, et cetera.

And that was because we were coming out of COVID, aggregate demand was very strong, monetary stimulus was still incredibly strong, interest rates were still close to zero, et cetera.

There were labour shortages, so there was real strong wage growth coming through on the back of that as well.

And all of that exacerbated the issue.

It’s why we saw such a high rate of inflation through that period.

Now, if we roll forward to today, actually the inflationary pressures we’re seeing are solely just on energy at the moment.

You’re not seeing the same sort of pressures on wages.

In fact, when you saw the wage data this morning, actually that’s coming in below expectations and has been falling over the last few months.

And as you can see on the chart on the right-hand side there, job vacancies have come down quite a long way.

And actually, the number from this morning shows that job vacancies are now at a 2014 level.

So we’re not seeing that pressure for wages to go up.

Also, aggregate demand in the UK is not as strong as it was.

We’re not suddenly coming out of COVID demand.

There’s not this huge pent-up demand.

So although we see inflation rising, we don’t see a return to 2022 and those double-digit levels as well.

Now, whether the Bank of England increases interest rates, I don’t think they’ll do it this week, as they’re due to report on Thursday.

Famous last words obviously.

But we’ll wait and see how we go through the second half of the year.

Now, as we start to annualise some of that impact from higher energy prices, it may give a bit more capacity for the Bank of England to remain on hold, and I think that’s kind of our central case.

The Bank of England will likely hold interest rates for as long as possible until we get some sort of resolution from the oil price spike that we’re seeing currently.

Now, what I would say as well is one of the things we’ve seen in the UK is actually UK GDP growth has been pretty resilient.

Now, don’t get me wrong, it hasn’t been boom time by any means.

But GDP growth, economic growth over the last few years has actually proved better in each year.

So 2023, 2024, 2025, actually GDP growth has been better than we all expected at the start of the year.

Economists were generally quite pessimistic about the prospects for UK economic growth because of the pressure we were seeing on household incomes from rising inflation, from rising energy bills, et cetera.

But what we’ve seen is it’s been a lot more resilient.

And now there’s a couple of factors to that, but I think it’s generally down to this left-hand chart here.

This just shows consumer balance sheets are incredibly strong.

Ever since the Global Financial Crisis back in 2008 and 2009, households have been deleveraging their balance sheets, actually to a point where we’re in a situation where we’ve got aggregate net savings in the UK.

Now clearly there are households that are suffering, et cetera.

But on an aggregate level, actually households are in good health in terms of low levels of debt and high levels of savings as well.

Also businesses and companies are in good health as well.

This chart on the right-hand side just shows you company balance sheets, the amount of debt they have as a percentage of GDP.

Again, we’re at very low levels as well.

We had that period from the GFC where companies were over-leveraged to now a position where they’re probably under-leveraged.

That’s helped us get through this.

And one thing we’re seeing at the moment, irrespective of the geopolitical tensions out there, underlying earnings growth has been particularly strong this year.

So let’s not get too depressed about where inflation is going, the geopolitical risk, when the underlying companies that we own are generating good levels of profit growth as well and are very strong financially.

Another thing to mention is probably here as well is the banking sector.

Again, that’s very well capitalised.

We’ve been through fifteen years of re-regulation and recapitalisation of the banking system.

So again, even if we do go into a more difficult environment, the financial positions of households, companies and the banking system are in a much better place than where we’ve ever been really.

And despite the UK market performing very well over the last five years, actually valuations are still pretty appealing.

So this chart shows you where the UK PE, so price-to-earnings ratio, is relative to its history.

And as you can see, even though we’ve had a strong performance, we’re actually only in line with the long-term average.

If you look at the boxes at the bottom of the slide, actually we’re relatively cheap versus other overseas equities.

So whether that be Europe, Japan, the US, Asia, et cetera.

So all those other developed markets, we are trading incredibly attractively as well.

So there’s still opportunities out there despite the good returns we’ve seen in the UK market.

As I mentioned before, the mid-cap area of the market has probably been one of the areas that’s been less positive than, say, the FTSE 100, but that gives you the opportunity, we think.

You know, if you look at the breakdown of the UK market by mid-cap versus large-cap, so FTSE 250 versus FTSE 100, again we’re seeing pretty cheap valuations there.

So on a PE basis, the FTSE 250 trades at a discount.

That’s unusual.

On a dividend yield basis, the FTSE 250 now trades at a premium to the FTSE 100.

Again, that is very rare and that’s only ever happened three times in history.

Once in the depths of the Global Financial Crisis, again within the TMT boom, and then another time during the ERM period.

Actually, those were triggers for the market to perform better.

So we started to see the FTSE 250 and the UK market broaden out to some of those more medium-sized companies.

Actually, we think there’s further to go and that’s where some of the opportunities we’re seeing are.

In terms of pulling out some of the names that we’ve been looking at recently, I’ll break them down into sort of three areas really.

I call them the first one kind of unloved.

So what do I mean by that?

The first one is Aberdeen, the asset manager.

You know, I do feel that it’s misunderstood.

Everyone still sees it, I think, as a poorly performing asset manager.

I think what that misses is the fact that they own Interactive Investor, which is a direct-to-consumer investment platform that is performing incredibly well at the moment.

Really growing customer numbers quite attractively because their fee structure is very competitive.

And I think that is being missed within the valuation of the overall company as well.

Dunelm is a homeware retailer in the UK.

I could have put any domestic equity, if I’m honest, or any domestic company.

These domestic businesses are very unloved at the moment, given people are fearful about what a new Prime Minister and what the Budget may do, weighing on some of these domestic names, whether it be retailers, housing-market-exposed stocks, et cetera.

But therein lies the opportunity.

Dunelm is now trading at valuations incredibly low relative to where it’s historically traded, but actually it still generates incredibly strong returns.

We think that can continue.

We like the new CEO.

She’s very dynamic.

We think she can reinvigorate growth in that business as well, and that’s clearly not discounted in where we are today.

The next bucket is really some of those unknown stocks.

Some of you may know them, but I think they’re not that well understood within the market.

So Bunzl, which is a global business, is actually in the FTSE 100.

A distributor across the globe, and it distributes not-for-resale products.

Think about plastic packaging for supermarkets, safety equipment for the building industry and things like that.

One of the things it’s been very proud of is its operational momentum.

The way it operates as a business has been very robust over the long term.

But actually they had a few issues in the US business last year, and that saw the shares come under quite significant pressure.

We were happy to buy into that weakness because we thought ultimately this is something the company could fix and solve, and ultimately they seemingly have, and their share price has started to move on that.

But actually when you look at where the valuation is today versus the long term, we still think it’s very undervalued and still a good resilient business to own over the longer term.

The next one is Coats, which is a market leader in supplying threads into the apparel and footwear markets.

I think it is very attractive when you take a step back.

It’s a global leader.

It’s got 20% margins.

It’s got good free cash flow.

It’s got a net cash balance sheet.

It’s ticking a lot of the boxes that we really look for in companies, and yet when you look at the valuation it’s trading at less than ten times earnings, which we think is just wrong.

So that’s another one we’ve been buying recently that we quite like and feel is not well understood by the market.

And then lastly, underappreciated companies.

So companies people have probably heard of, but we think their investment case is probably underappreciated.

Firstly is Standard Life.

So this is the old Phoenix business, which used to be just a closed life insurance company consolidator.

So it would only grow if it bought something, stripped out a load of costs, et cetera, and that was the only way it was able to effectively grow its business.

Whereas now, actually, it’s much more about organic growth.

It’s now very well positioned in the workplace pension market, which obviously has structural underpinnings from government regulation about people saving for retirement.

So what I don’t think people have really understood is the fact that now organically the cash flows of the business have grown at mid-single digits, but it’s still being priced as a closed-life consolidating business, which it’s not.

It’s transformed that business over the last five to six years, where actually you’re seeing good organic free cash flow growth there.

And lastly, Johnson Matthey, which makes catalytic converters for petrol and diesel cars.

Again, people worry about the long-term structural growth of that business given the move to electric vehicles.

But I think what people miss is the fact that as you manage the wind-down of your petrol and diesel business, actually you can generate a lot of cash from that and actually grow that cash flow as well, given they have a refining business of platinum group metals.

I don’t think that’s being discounted, the fact that it generates a lot of cash and will generate even more as we go forward.

So those are just a whistle-stop tour through some of the opportunities we’re seeing in markets currently.

Probably won’t go through these slides in great detail, just performance of the trust.

We’ve done well in terms of absolute returns, so the NAV growth over the shorter, medium and longer term, and thankfully outperformed the market over that time period as well.

I probably won’t go through this slide in much detail, but you can see on the left-hand side the sector exposure within the equity portfolio, and then our top ten holdings on the right-hand side there.

Again, I won’t go through the individual names, but obviously we’ll be happy to take questions on any of those or any other companies as well.

And I think if you invest today, one of the advantages of investing in investment trusts is that there are swings in the rating of investment trusts.

So where a share can see investment trusts trading at a premium or discount.

Currently we’re trading at a discount to our NAV of around 4%.

So it gives an opportunity for people to buy in at a slight discount to where the NAV is.

So I’ll quickly sum up now.

I’ve probably bored you enough and we’ll move on to Q&A.

But why would you consider Henderson High Income as an investment?

Firstly, we’ve got a high and growing dividend stream.

So a 5.4% dividend yield, and we’ve grown that dividend every year for the last 13 years.

We have an experienced and dedicated income team, strong investment trust heritage, and an average of 20 years’ experience.

A clear focus on income sustainability, having that diversified portfolio, but also utilising the investment trust structure and having seven months’ worth of revenue reserves.

And through our disciplined, simple, understandable investment process, we’ve delivered good outperformance over the short, medium and longer term.

But I’ll pause there and happy to open up to questions.

Vijay: Brilliant, David. Thank you very much for a very interesting presentation.

We have got one question here.

How much revenue reserve does the fund have? If there was no payout from the portfolio, how long would the revenue reserves last?

David Smith: So we’ve got 60% cover on the dividend in one year from revenue reserves.

So that gives you an idea.

If, in the very unlikely scenario that none of the companies we own paid a dividend, then clearly we would go through those revenue reserves quite quickly in the year, but I think that’s a very unlikely scenario.

If we think back to the COVID period, so 2020, the FTSE All-Share dividend income was down 40% in that year.

We only had to use a modest amount of revenue reserves in that year.

So that was the worst year for income investors certainly in my lifetime, and we only had to use about 16% of our revenue reserves.

So quite a modest amount over that year.

That probably puts it in a bit more context about how much those revenue reserves can support you over the longer term.

Vijay: Great. Thank you.

I have a question as well, David.

You said that the investment case for this 5.4% yield, your opening slide showed that the differential between what the 10-year gilt is is only marginal now.

Could you give us some idea of historically, presumably, that differential was much greater?

Yeah, and so the proposition was obviously a lot stronger then.

With that in mind, and also the fact that we have a high inflation market, what’s likely to stay high inflationary and yields are likely to stay high, what do you see going forward?

David Smith: So you’re right.

The differential between how much Henderson High Income yields versus 10-year government yields is close, and it’s probably more at parity where we are exactly today.

I suppose the argument is, though, because we invest in equities, essentially the propensity for capital growth is a lot larger for Henderson High Income versus a sole investment in UK government bonds.

And also we’ve got the potential for dividend growth as well.

So although the yields are the same, Henderson High Income would ordinarily give you potential for dividend growth, so for that income to grow over time.

But also the potential for capital growth because you’re investing in a portfolio where the majority is equities.

So I still think even if the yield went below what you could get on a 10-year gilt, actually there’s a different proposition there from Henderson High Income, given that ability to give you a bit of growth on your capital but also your income.

Vijay: Okay. And that’s why you focus on the FTSE 250?

David Smith: Yeah, so, well, we’re balanced between large and mid-cap.

What I would say, within the equity portfolio, I’d say we were roughly 65% large cap, so FTSE 100, and 35% mid and small cap.

Vijay: Okay.

David Smith: But that’s still probably underweight large cap versus the FTSE All-Share, if that makes sense.

Vijay: Okay. And just on that, I have a specific question, I think, from one of the audience.

What makes you so upbeat about the FTSE 250 and micro-cap?

David Smith: We don’t do micro-cap.

Vijay: Oh, okay.

David Smith: So our limit is probably around about £500 million market capitalisation.

So that’s probably towards the lower end of the FTSE 250.

We generally don’t go into small-cap micro-cap.

What makes me so positive?

I think it’s valuation really.

When you look at some of the valuations some of these good-quality companies are trading at, they’re kind of pricing in a recessionary scenario, and I think the UK economy has been a lot more resilient than people expected, and I don’t think we’re necessarily going into a recession any time soon.

But yet the valuations are discounting that.

Now, clearly if the market is not going to appreciate some of that value, there’s another area of the market that is, and that’s corporate activity.

We’ve seen quite a significant step up in acquisitions over the last few years, whether that’s private equity, whether that’s overseas companies seeing real value within the UK mid-cap area of the market.

And I think if we don’t recognise that value ourselves, that will just continue.

Also, companies are seeing value in their own businesses.

Again, you’re seeing quite a lot of support from companies buying back their own shares.

So as long as they’re utilising excess cash that’s not needed for investing in their business, actually that’s quite a good discipline to highlight to the market that you think your shares are cheap and buying them back in.

Vijay: Great. Thank you.

I have a couple more questions here.

Are all your bonds in sterling?

David Smith: So they’re not.

We can go 30% overseas.

And we utilise that across both the bond portfolio and the equity portfolio.

I’d say we’re around about 18% currently, 9% bonds and 9% within the equity portfolio.

What the bond team find is actually the UK bond market’s quite concentrated in terms of sectors.

So they can go into the US bond market and they can go into the Euro bond market.

There are deeper pools of capital and more opportunities to diversify their portfolio.

What we do do, though, is hedge back that currency exposure within the bond portfolio through the gearing.

So where we can borrow in US dollars, where we can borrow in euros, we use that to fund a euro bond and use that to fund a US dollar bond as well.

Vijay: Brilliant. Thank you.

And I have one more question from the audience.

You talked about the structural debt and tactical debt.

How much is financed?

Do you change the tactical debt to match market conditions?

What might be the upper and lower ranges?

David Smith: Yeah, so it’s a good question.

The structural debt, the long-term fixed-rate borrowings, will always be fully invested and they’ll be invested in the bond portfolio because there’s a good spread there for generating extra income.

We’ve also got a revolving credit facility, which we use, which is based on a spread over short-term rates.

And again, we say that’s more tactical, so we can move that about a bit more.

If we’re feeling a lot more bullish about life, or if we think valuations are particularly attractive, we will push that out.

If we’re feeling a bit more negative, a bit more bearish, we’ll pull that back in.

I suppose if you look at where we’ve been, certainly since I’ve been on the trust, in terms of our gearing levels, I’d say we’ve been anywhere between about 18% and 25%.

Currently we’re around about 19%, or just shy of 19%.

So more towards the lower end of that.

And I think that just says that the UK market has done particularly well.

There are worries about geopolitics.

I’m not particularly worried, but I think it just makes a bit of sense to pull a little bit of risk off the table for the time being and be towards the lower end of that typical range we’ve been in over the longer term.

Vijay: Sorry, just so I can understand that.

So you’re saying that 25% was the net gearing?

What would be the structural element of that?

David Smith: The structural element is about 40/60.

So 40% is fixed-rate borrowings.

Vijay: Right.

David Smith: And 60% is revolving credit, variable borrowings.

Vijay: Right. Right. Right.

Okay.

But in terms of the bond portfolio that you invested in, you said that’s about 12% at the moment.

David Smith: Yeah, about 12%.

Vijay: And historically that was 18?

David Smith: No, no, no.

So the overall gearing.

If you include bond gearing and equity gearing, that’s been between a range of 18% and 25%.

So 19% is just if you think about the total gearing in the investment trust.

We’re towards the bottom end of that total gearing range.

Now bonds, if you think about how much we own in bonds, so 12% of NAV at the moment, we’ve been higher, towards more like 20%, at certain points in time in the past as well.

Vijay: Great. Thank you.

I have one more question here.

Do you invest in index-linked or conventional bonds only?

If so, what is the percentage between the two?

David Smith: So we can invest in government bonds.

We can invest in corporate bonds, both investment grade and high yield.

Currently what we invest in is mainly investment grade corporate bonds and some high-yield bonds.

I’d say at the moment we’re around about 50% in investment-grade corporate bonds and about 50% in corporate high-yield bonds.

The bond team look at and pick the actual individual bond holdings.

Where they go into the high-yield area of the market, it’s typically in pretty defensive corporates with strong reasons to exist and the ability to sustain a high level of debt on their balance sheets.

We’re typically at the higher-quality end of the high-yield market when we go there.

Vijay: Brilliant. Thank you.

David, that concludes all the questions from the audience.

If I may indulge, I have a question.

Sure.

I mean, you were very good in describing the framework of how you buy, what it is that you buy, and what makes it into the portfolio in terms of income sustainability based on fundamentals, financials and valuation.

And then you talked about your unloved, unknown and underappreciated categories and gave us examples there.

What is the equivalent framework for when you sell?

Is it valuation-triggered?

Is it fundamentals-triggered?

Is it income-triggered?

And in practice, which one of those actually dominates?

And, as a follow-up question, can you just talk us through the last holding that you actually sold?

What specifically triggered that decision?

And how long was it between getting the first warning sign and actually getting it out of the portfolio?

David Smith: Yeah, good questions.

So there are a couple of reasons behind our sell discipline.

Why would we sell something?

Firstly, if we’re going to buy something with a valuation discipline, we’re going to sell something based on a valuation discipline.

Clearly when stock prices rise and the valuation gets above our target, then, as long as the investment case hasn’t changed to justify moving that valuation target up, that’s a reason to sell.

Actually, being an income fund manager is quite helpful in that regard.

Typically we are buying stocks that probably have a yield premium to the market.

Clearly if the yield drops too low and we have to sustain the portfolio income, we need to justify why we’re still going to own it if we have to make the rest of the portfolio work harder to compensate for that lower yield.

So that’s a good discipline to have.

Secondly, if there’s a change in the investment case.

For whatever reason.

A good example is the inflation problem of the last couple of years.

If a business hasn’t been able to manage that inflation in its cost base, where margins get squeezed, then the profitability outlook for us has been wrong.

And we should move on from a company if we think the investment case doesn’t hold anymore because of that change in the environment.

And the third point is probably just that we made a mistake.

We got something wrong.

The key attributes that we found didn’t hold, et cetera.

And you’ve got to be unapologetic in this job.

You can’t just stick around with something if you think you’ve got something wrong.

You’ve got to move on from it.

This brings me to my example.

Last year we bought Telecom Plus, which is an aggregator of utility services.

So it’s a one-stop shop to get all your utility needs, your energy bills, mobile bills, broadband, et cetera.

And I’ll hold my hands up, we got it wrong.

We had disappointing results.

We saw the management team.

It was clearly apparent they were trying to do acquisitions at low returns, which didn’t really make any sense to us.

Customer growth was going backwards.

They felt like they needed to reinvest back into the business to get the competitive nature of the business back and win customers back.

But we didn’t get the proper answers we wanted when we questioned the company.

So we bought it, it was a poor performer, we sold it, and then the share price got even worse.

So actually even though it was painful owning it, and painful selling it because you always want to be right, you’re not always going to be, let’s be clear, it was the right thing to do to sell it and move on from it.

The other thing to talk about in terms of sale discipline is what happens when a company cuts its dividend.

And I think we’re always of the view that if it’s the right thing to do, if they’re over-distributing, but it’s the right thing to do to fix a balance sheet and reinvest back in the business, then actually we’re happy to continue owning the company through that period.

The good example is probably Diageo.

Clearly Dave Lewis, the new CEO, came in and cut the dividend because the balance sheet was too stretched and they were paying out too much cash flow in terms of that dividend.

Actually, it was the right thing to do to reinvest in the business.

And having listened to the strategy day they’ve had in the last month or so, actually we think this could be quite an interesting turnaround story from here.

So although painful at the time for the income, don’t forget we’ve got that diversification.

Actually, on the capital side, it was the right thing to do for the business.

And from here we think it could be quite an interesting stock as it turns around.

Vijay: Great. Thank you very much.

And thanks for being so clear in your response there.

That was very interesting and very informative.

I have no more questions on the screen.

And I could ask you loads more questions, but I’m going to resist.

But thank you very much.

I think we’ve got all we need.

That was a great presentation.

Thank you very much, David.

David Smith: Pleasure.

Thank you very much, Vijay.

And thank you to everyone listening.