Henderson International Income Trust — Update 15 December 2015

Investors are becoming increasingly concerned about the prospects for dividends from the largest companies in the FTSE 100. According to the Capita Dividend Monitor, for Q315 the UK’s top five dividend payers accounted for 31% of total dividends, and the presence of BP and Shell in this number could see dividends come under pressure if oil prices remain lower for longer. (The UK is not alone in its high level of dividend concentration, however: according to the Henderson Global Dividend Index, c 90% of Swiss dividends come from the country’s top 20 payers, compared with
c 70% for the UK.) Meanwhile, the level of dividend cover for the FTSE 100 (ie the relationship of company earnings to dividends paid) was less than 1.5x in late November, suggesting wider growth/sustainability issues in an environment where earnings growth continues to be subdued.

One solution for UK investors concerned about dividend income could be to look overseas. Although the UK punches above its weight in terms of its share of global dividends, generating 13% of 2014 dividends compared with a 7% weighting in the MSCI AC World index (Exhibit 2), that still leaves 87% of global income coming from elsewhere. Europe ex-UK and developed Asia Pacific also contribute a greater proportion of dividends than their index weighting would suggest and, while the US and Japan are lower yielding in aggregate, stock-specific higher yield opportunities may be found.

In an environment where risk awareness may be higher, given fears over growth in China, war in the Middle East and the future path of US and UK interest rates, investors may also wish to consider the importance of sustainable dividends in producing positive total returns in periods of volatility.

Henderson International Investment Trust (HINT) seeks to provide a high and rising income from dividends, as well as long-term capital growth, by investing outside the UK. It was launched in April 2011, in part as a rollover vehicle for investors in Henderson Global Property Companies. The manager since launch, Ben Lofthouse, is assisted by a team of global equity income specialists and draws on Henderson’s wider regional investment teams.

A relatively focused portfolio of c 60 stocks, HINT is diversified by geography and industrial sector. Its benchmark is the MSCI World ex-UK index – a large universe of c 1,500 stocks – although the portfolio is built from the bottom up with little reference to index weightings. HINT is unusual among its global equity income peers in that it explicitly excludes the UK; the idea of the trust is to provide diversification (particularly in terms of income) for investors who may already have sufficient UK exposure. Dividends are paid quarterly and have grown ahead of inflation since launch.

Dividend growth is key for an equity income fund, and Lofthouse points to a surprising figure for the sector with the best growth record: from Q409 to Q215 technology stocks globally saw annualised dividend growth of 19% in dollar terms, with further surprises possible from US tech stocks sitting on large cash piles. In spite of a more challenging backdrop, with fears emerging for UK investors in particular over sustainability of dividends, HINT saw only one cut in FY15, from Italian oil stock ENI.

Lofthouse says the HINT portfolio is broadly but not aggressively positioned for economic recovery. In a normalising interest rate environment cyclical sectors such as technology tend to outperform, while defensive areas like consumer staples may struggle. However, with QE still ongoing in areas such as Japan and Europe, the manager is keeping a balance in the portfolio, with sensibly valued stocks in areas such as healthcare and telecoms alongside more cyclical financials and industrials.

Valuation is a key focus, although Lofthouse warns that the ‘deep value’ end of the market has a more cyclical tilt than usual, as banks and oil companies are currently out of favour and hence trade on cheap valuations. The manager is instead focusing on areas such as pharmaceuticals that have defensive qualities but are less expensive than consumer staples stocks, which have been driven to high valuations by investors looking for bond-like reliability of income in a world of low bond yields. “Drug companies are trading more cheaply than Kellogg’s and they are very cash-generative,” says Lofthouse, although he acknowledges risks from political pressure on pricing and the regulatory environment, and remains underweight healthcare versus the index as a result.

While bond proxies have performed well, the manager says ‘hopeful growth’ stocks such as biotech and internet companies like Uber have also been driving the market in recent years, meaning that value and income have been left behind somewhat. Overall, however, equity returns in 2015 have been disappointing, with emerging markets the worst performers but defensive assets such as bonds and property doing well. While the future path of emerging markets is far from certain, Lofthouse says the declines could lead to opportunities in fundamentally undervalued companies in these areas, which could see an uptick in gearing from the current low level of c 4%.

HINT manager Ben Lofthouse is a member of Henderson’s global equity income team, headed by Alex Crooke, which has grown substantially in recent years and now has nine portfolio managers and analysts. The team takes a bottom-up approach to investing, defining its universe as stocks in the MSCI World index that have dividend yields of 2%+, attractive free cash flow yields and strong free cash flow growth. HINT aims to achieve a yield at least equivalent to that of UK equities.

Stocks in the global equity income universe are assessed on their business fundamentals, with the manager seeking companies with defensible competitive positions, affordable investment requirements, management whose interests are aligned with those of shareholders, and sustainability of returns. Such companies should contribute sustainable profits, cash flow and dividends to the portfolio. In addition, the manager targets capital growth from unloved and undervalued companies whose earnings are underappreciated by the market.

Lofthouse manages the allocation between HINT’s three regional portfolios, North and South America, Europe ex-UK (including the Middle East and North Africa) and Asia Pacific (including Australasia). He is able to draw on the expertise of fund managers outside the global equity income team, such as Henderson Far East Income fund manager Mike Kerley, who contributes Asian stock ideas. The manager also sets the level of gearing (up to 25%) in response to available opportunities. The end result is a portfolio of c 60 companies, roughly one-third from each region. While the number of stocks is broadly equal across regions, weightings may vary. Stocks may be sold if valuation targets are reached or if there is a fundamental change in the investment case.

HINT’s mandate includes the flexibility to hold bonds as well as equities. Lofthouse has not yet used this power and says he would only do so if he were extremely cautious on the outlook for equities. Currency hedging may be employed, although this tends only to be used when the portfolio is significantly overweight in a given currency, rather than as a view on the likely direction of interest rates. The manager may also make limited use of option writing to enhance income.

At 31 October HINT had 67 holdings, slightly above the target range of 40-60 and higher than six months ago. This is a shorter stock list than the peer group average of 93.5, although with 25.4% of assets invested in the top 10 stocks, HINT is less concentrated than the sector average of 30.8%.

The largest allocation is to financials; the 31.9% shown in Exhibit 3 includes 12.1% in real estate, including Netherlands-listed shopping centre operator Eurocommercial and French stocks Icade, a commercial property REIT, and Nexity, a mass-market housebuilder. Lofthouse says European property stocks are undervalued (all three stocks were bought below book value) and offer good yields. There is also a large overweight to telecoms, with eight stocks diversified by geography. Favourable fundamentals for the sector include increasing customer spend on 4G data services, and a regulatory environment generally more inclined to allow consolidation, leading to greater pricing power for the remaining operators in each market. Companies held include SK Telecom in Korea and Bezeq in Israel, bought at 12x P/E and with a dividend yield of 8%.

Oil and gas exposure was reduced before the worst of the oil price falls, with sales of oil services companies predicated on greater supply and demand equilibrium in the sector. More recently Lofthouse has bought US oil major Chevron (now a top 10 holding). Consumer goods weightings have been trimmed as ‘bond proxy’ stocks in the sector become increasingly expensive. Some of the proceeds have been deployed in an increased allocation to healthcare, where a new holding in Johnson & Johnson has provided consumer staple-type exposure at a more favourable valuation.

Geographically, HINT is structurally underweight the US (by 20.5 percentage points versus the index) and Japan (by 8.2 percentage points) because these markets are on average low-yielding. All regions must contribute to the overall portfolio yield. At 31 October 44% of the portfolio was in North American stocks, on an average P/E of 15.9x and with a dividend yield of 3.6%. European stocks (35% of assets) had an average P/E of 16.0x and a dividend yield of 4.5%, while Asia Pacific including Japan (24%, with Japan at 1.3%) had both the cheapest stocks and the highest yield, with an average P/E of 13.5x and a dividend yield of 4.8%.

Over 12 months to 30 November HINT’s share price total return is ahead of the MSCI World ex-UK index, although over most other periods both share price and NAV returns are in line with or somewhat behind the benchmark (Exhibit 4). The manager points out that because of its focus on dividends, the trust tends to be structurally underweight the lower-yielding markets of the US and Japan, which are the two largest constituents of the benchmark and have also produced some of the strongest capital performance in the period since HINT’s launch. Returns in FY15 were also hit by the strength of sterling. The importance of dividends in total returns is underlined by the fact that HINT’s positive NAV performance for FY15 was made possible by income (even allowing for unfavourable currency moves) outweighing a small capital loss.

As seen in Exhibit 5, HINT has since launch fulfilled its aim of rewarding investors who venture overseas with better returns than they could have achieved from the UK index: both NAV and share price total returns have beaten the FTSE All-Share over almost all periods since inception.

In FY15 the top five contributors to performance versus the benchmark were tobacco giant Reynolds American, theme park operator Six Flags Entertainment (a longstanding holding), defence company Lockheed Martin, Chinese online games stock NetEase and German stock exchange operator Deutsche Börse. Lofthouse describes these as a mix of growth stocks and more stable defensive names. The most significant detractors (relative to the index) were Korean companies SK Telecom and Hyundai Motor, oil stocks ENI and Petrochina (although oil exposure was cut substantially during the year) and mid-cap Canadian loyalty card operator Aimia, which has a 10% free cash flow yield and an 8% dividend yield, but has struggled to achieve earnings forecasts following a new airline loyalty card contract agreed in 2013. Lofthouse comments that investors are wary of companies with narrow end-markets, so these tend to get punished more by falling share prices in the event of any wobbles.

At 14 December HINT’s shares traded at a 0.5% premium to cum-income net asset value. On average the shares have traded at a premium of 1.3% since launch. The final exercise of subscription shares in September 2014 may have caused temporary oversupply of HINT’s shares; the discount hit an all-time widest of 8.3% on 3 September that year, but has since closed back up and has traded at an average premium of 1.0% over the past 12 months. HINT may buy back up to 14.99% of shares to manage a discount (a power not used to date) and uses tap issue to meet demand. So far in 2015, 3.9m shares have been issued, raising £4.9m.

HINT is a conventional investment trust with one class of share. At 14 December 2015 there were 80.25m ordinary shares in issue, an increase of 5% on 12 months previously as new shares have been issued to meet demand. At the beginning of FY15 the final exercise of subscription shares also added 8.3m shares to the total in issue.

At its 31 August 2015 year end, HINT had gearing of 6.3% through a £20m overdraft facility with HSBC; £6.0m was drawn at FY15 (FY14: £6.7m). Net gearing had fallen to 4% at 31 October.

Henderson Global Investors is paid an annual management fee of 0.75% of net assets (this was reduced from 0.8% in November 2013, when a performance fee structure was also removed). Ongoing charges for FY15 were 1.11%, a small increase on the 1.09% for FY14, reflecting costs associated with the final exercise of subscription shares.

HINT pays dividends quarterly, in February, May, August and November. The total dividend for the year ended 31 August 2015 of 4.5p per share was 5.9% higher than for FY14, a significantly above inflation increase, in spite of pressure on the income stream (which all comes from overseas) from the strength of sterling. While historically the board has raised the dividend at the fourth interim, setting the bar for the first three dividends of the following year, in FY15 the first two dividends were 1.1p each and the third and fourth were 1.15p. Since launch the dividend has grown at a compound annual rate of 2.7% (using the annualised dividend for the first financial period). The FY15 dividend was fully covered by income of 5.14p per share and the trust added to its revenue reserve, which now stands at £2.4m, sufficient to cover 70% of the dividend.

HINT is a member of the AIC’s Global Equity Income sector, although it is the only fund in the group to focus exclusively outside the UK. There are 10 funds in the sector and HINT’s NAV total return performance has been well above average over both one and three years (it does not yet have a five-year track record). Risk-adjusted performance as measured by the Sharpe ratio is above average over one and three years. Half of the peer group currently trades at a premium to NAV; HINT’s premium was among the smallest in this group at 14 December. The trust has the joint lowest dividend yield in the group; this may be a reflection of its lack of exposure to the UK, though the 3.9% yield is broadly in line with the FTSE All-Share (ex-ICs). Ongoing charges are somewhat above average, while gearing is towards the lower end of the peer group range.

HINT’s four non-executive directors have all been in post since the trust’s launch in 2011. Chairman Christopher Jonas was also chairman of the predecessor vehicle, Henderson Global Property Companies (HGPC), and has a background in property. Peregrine Banbury – another former HGPC board member – and Bill Eason formerly worked in investment management, while Simon Jeffreys’ professional background is as an accountant and business manager.