Standard Life Equity Income Trust — Accelerating dividend growth

The potential benefit to investors from investing in smaller-cap stocks is shown in Exhibit 2 (left-hand side). Over the past five years, the FTSE 250, SmallCap and AIM 100 indices have all meaningfully outperformed the large-cap FTSE 100 index. While large-cap stocks are generally trading at more favourable valuations than smaller-cap companies (right-hand table), they do not have such attractive growth profiles and dividend cover is lower. Although there are economic uncertainties, including ongoing Brexit negotiations, for investors seeking exposure to UK equities, a fund invested across the capitalisation spectrum, with a bias to smaller-cap companies and a focus on income, may be of interest.

SLET was launched in 1991 and is traded on the Main Market of the London Stock Exchange. The trust aims to generate an above-average level of income, along with above-inflation growth in capital and income from a diversified portfolio of 50–70 UK equities. There are investment limits in place: no individual position will exceed 10% of net assets and the top 10 holdings are limited to 50% of net assets. SLET operates between net gearing of 15% and net cash of 5%; at end-May 2018, net gearing was 11.8%. The trust has been sole-managed by Thomas Moore since May 2012 (having been co-manager for the previous six months). He adopts an unconstrained investment approach, meaning that the trust’s stock and sector weightings can vary significantly versus the index. For example, c 45% of the portfolio is invested in financial stocks compared to a c 25% weighting in the benchmark FTSE All-Share index. SLET also has a much higher weighting to mid- and small-cap stocks, c 70%, which compares to c 20% in the benchmark. The board believes that a focus on undervalued income stocks, whose positive fundamentals are being overlooked by the majority of investors, as well as an unconstrained investment approach, will generate good medium- and long-term returns for shareholders.

Moore is positive on the investment backdrop in the UK, due to a benign interest rate environment, domestic and global economic growth, and robust corporate earnings growth. While mindful of macroeconomic risks such as ongoing Brexit negotiations and the impact of a trade war, he says there are sectors and individual companies, with attractive fundamentals, that are trading on reasonable valuations. Moore notes that so far in 2018, there has been a polarisation within the UK stock market – investors have been focused on growth rather than value stocks. This has affected SLET’s investment performance as it follows the investment manager’s Focus on Change investment philosophy, which seeks companies with strong cash flow and dividend prospects that have potential for a rerating.

The manager says that in general, companies are delivering on what they have set out to achieve. However, due to investors’ focus on growth stocks, not all companies delivering positive results are enjoying an uplift in valuations. Moore notes that looking at SLET’s Q218 performance attribution, the companies that have been the largest detractors have not actually delivered any negative news. He remains confident in the prospects for the trust’s portfolio companies and believes the general lack of focus on valuations is providing attractive investment opportunities.

Moore and his team employ an unconstrained investment approach. They seek to invest in undervalued companies, whose share prices do not reflect positive fundamentals or the potential for improvement. Meeting company management is a key element of the investment process; members of the investment team conduct more than 3,000 company meetings each year. They look to uncover changing dynamics within individual companies and the markets in which they operate, which could lead to an increase in a firm’s earnings and dividends. An improvement in investor sentiment towards a company will invariably lead to a higher valuation being placed on the business. The Focus on Change investment philosophy is based on the theory that at different stages of the economic cycle, there are different drivers of stocks and markets. The belief is that over the long term, a company’s share price is driven by its underlying fundamentals but share price moves can be less rational over shorter time periods. Aberdeen Standard Investments has a proprietary stock matrix to screen the c 1,500-company universe; factors include earnings growth and revisions, share price momentum and valuation. Companies passing the stock selection screen are then subject to in-depth analysis taking into account the following five considerations:

The unconstrained investment approach means that SLET’s stock and sector weightings vary considerably compared with those in the benchmark FTSE All-Share index. Individual weightings reflect Moore’s level of conviction, which is based on an assessment of a company’s management team, its strategy, business prospects and valuation. The manager notes there can be significant opportunities in companies that are under-researched by buy- and sell-side analysts. An evaluation of a company’s corporate governance track record is an increasingly important part of the investment process; evidence suggests that companies that align their interests with those of shareholders may achieve above-average returns. The investment manager is aware of the need to measure portfolio risk; the company has a sophisticated risk-modelling system, which includes pre-trade analysis.

At the end of May 2018, SLET’s top 10 positions made up 30.4% of the portfolio, which was an increase in concentration compared with 25.9% a year earlier. The manager’s unconstrained investment approach is illustrated in Exhibits 1 and 3; for example, only c 30% of the portfolio is invested in large-cap FTSE 100 stocks and the trust’s sector exposures are meaningfully different to those in the index. Most notable are the c 20pp overweight in financials and the c 10pp underweight positions in consumer goods.

Looking at some of SLET’s recent new holdings illustrates the manager’s index-agnostic approach. Moving down the market cap spectrum means he is able to find more companies with attractive valuations and growth potential.

Charles Taylor (AIM listed, market cap of c £235m) provides insurance administration services such as claims management. The manager says the company’s InsureTech platform is a significant potential organic driver for the company. He believes Charles Taylor has an attractive growth profile and is trading at an attractive valuation.

Diversified Gas & Oil (AIM listed, market cap of c £375m) acquires gas assets in the Appalachian region. It is able to purchase these at attractive valuations as the major oil companies are selling their conventional assets to focus on shale operations. Diversified Gas & Oil’s increased scale means operating expenses per barrel are coming down dramatically. The manager says the company’s latest acquisition (announced in June 2018) is 30% accretive to earnings; the announcement of the deal led to significant share price appreciation.

Urban Exposure (AIM listed, market cap of c £180m) is a lender in the residential development sector. Since the global financial crisis, banks have been required to build up significant capital on their balance sheets, which has allowed companies such as Urban Exposure to grow their lending expertise without having the same capital requirements. SLET participated in the company’s initial public offering in May 2018.

Recent sales include drinks manufacturer Britvic, house builder Countryside Properties and packaging company DS Smith, which had all appreciated strongly, meaning the manager no longer considered their valuations attractive. Vodafone was sold as Moore believes the gap between the company’s cash flow and its dividend payment is insufficient for him to have confidence in a higher distribution.

In H118 (ending 31 March), SLET’s NAV and share price total returns of -4.3% and +0.4% compared with the benchmark’s -2.3% total return. This period included a sharp pullback in equities during February and March due to concerns about higher US interest rates, with the FTSE All-Share index falling by c 11%. The best contributors to performance included small-cap investment managers Premier Asset Management and AFH Financial Group, along with emerging market debt manager Ashmore Group. The largest negative contributor was Micro Focus, which issued a profit warning due to integration problems following its merger with HPE Software; the manager believes these issues are temporary and he continues to hold a position in the stock.

SLET’s relative performance in shown in Exhibit 5. Its NAV total return has outperformed the benchmark over five years and since Moore was appointed manager in November 2011, while lagging appreciably over three years and modestly over one year. As shown in Exhibit 6, the trust’s three-year performance was negatively affected by its exposure to companies with domestic earnings following the result of the UK’s European referendum in June 2016.

Over the last three years, SLET’s widest discount to cum-income NAV was 11.3% on 3 November 2016, when there were stock market jitters ahead of the US presidential election. The trust’s discount has since narrowed and, so far in 2018, its shares have traded close to NAV. The current 0.1% discount is narrower than the historical averages over the last one, three, five and 10 years (range of 2.4% to 3.9%).

SLET is a conventional investment trust with one class of share; there are currently 49.2m ordinary shares in issue. The trust has a £30m lending facility with Scotiabank (Ireland); at end-May 2018, net gearing was 11.8%. The debt facility expires in December 2018, and the annualised cost of borrowing in H118 was 1.31%.

The investment manager is paid an annual management fee of 0.65% on the first £250m and 0.55% of total assets above £250m. Prior to October 2016, the fee was a flat 0.65%. Costs are split 30:70 between the revenue and capital accounts respectively, reflecting the board’s expectation of the allocation of long-term returns between income and capital. In FY17, ongoing charges were 0.87%, which was 9bp lower than in FY16.

SLET pays dividends quarterly in March, June, September and January. Along with the announcement in February 2018 of the first 4.4p per share interim dividend, the board stated its intention to pay the same amount for the second and third interim dividends and a higher final dividend of at least 5.5p per share. This minimum 18.7p per share distribution in FY18 is 9.4% higher than the 17.1p per share paid in FY17; the board expects the larger dividend to be fully covered by current-year earnings. The forecast dividend growth is meaningfully higher than the 6.0% compound annual growth over the last five years, as well as compared with the rate of UK inflation over the period. A higher total dividend in FY18 would mark the 18th consecutive annual increase. Revenue reserves have built significantly since 2011; at end-FY17 they were £6.7m (after taking into account the third and fourth interim dividends). This is equivalent to c 0.8x the total FY17 dividend payment. Based on its current share price, SLET has a dividend yield of 3.8%.

Exhibit 8 shows the 15 largest members of the AIC UK Equity Income sector; SLET is one of the smallest trusts in the selected peer group. Its NAV total return is above average over one and five years, while trailing over three and 10 years. The trust experienced a period of meaningful underperformance following the UK’s European referendum in 2016, as a result of its high exposure to companies with domestic, rather than international, operations. SLET is once again finding favour with investors, who may be encouraged by the board’s commitment to higher dividend growth, and has returned to trading close to NAV (Exhibit 7). The trust’s ongoing charge and level of gearing are higher than the selected peer average, and it has an above-average dividend yield, ranking eighth out of 15 trusts.

There are five directors on SLET’s board, all of whom are non-executive and independent of the manager. The chairman is Richard Burns, who was appointed as a director in 2006 and assumed his current role in 2014. The four other directors and their year of appointment are: Jeremy Tigue (2014 and senior independent director from 2015), Josephine Dixon (2011), Mark White (2013) and Caroline Hitch (2017).