Standard Life Equity Income Trust — Update 6 June 2016

After three years of broadly positive performance, UK stocks have struggled to advance in recent months, hit by fears over the global economy, US interest rate policy, growth in China and, closer to home, the looming referendum over Britain’s membership of the EU. As we enter the summer, when trading volumes tend to be low, volatility may persist, although a leg up in share prices may occur if, as widely expected, the UK votes to remain. As shown in Exhibit 2 (left-hand chart) below, small- and mid-caps have outperformed over the past five years, with the exception of those in the AIM Index. However, nervous investors have shown a preference for large-caps, given their greater perceived security, and valuations on the FTSE 100 Index (right-hand chart) are higher as a result. The high yield on the FTSE 100 comes with a caveat, however: dividend cover is historically low (see The manager’s view) and smaller stocks may offer more sustainable yields.

Standard Life Equity Income Trust (SLET) was launched in 1991 by Morgan Grenfell (later Deutsche Bank); the mandate was won by Standard Life in 2005 following Deutsche’s decision to exit the UK funds market. Originally managed at Standard Life Investments by Karen Robertson, it has been run by Thomas Moore (initially as co-manager until May 2012) since November 2011. Moore also manages the open-ended Standard Life UK Equity Income Unconstrained fund. Both funds follow an unconstrained investment style, with a higher weighting in mid-sized and smaller companies than the FTSE All-Share Index benchmark. The trust aims to achieve an above-average dividend yield as well as capital and income growth. It is a member of the Association of Investment Companies’ UK Equity Income sector, a large and competitive peer group, in which the trust ranks in the first or second quartile for NAV total return performance over one, three, five and 10 years.

As a manager with a focus on growing dividends, Thomas Moore remains concerned by the level of dividend cover on some large UK stocks. Several FTSE 100 companies have cut their dividends in recent months, starting with food retailers such as Tesco and Sainsbury, some of the utilities, all of the major mining stocks and the banks Standard Chartered and Barclays. Management change at GlaxoSmithKline, credit rating fears at BP and Shell and caveats by HSBC in its last results make the dividends on these four stocks (all on dividend cover of c 1x), which together make up c 18% of the blue-chip index, look vulnerable, argues Moore.

He points out that SLET’s unconstrained, multi-cap approach allows him to look beyond the big names to find dividend growth potential that has not been priced in. While in aggregate dividend cover on the FTSE All-Share is as low as it was in the bear markets of 2002 and 2009, cover on the FTSE 250 is relatively healthy, with revenues at more than 2x the cost of dividends, and Moore notes that many FTSE 250 and smaller companies are still growing their earnings, making future dividends more sustainable. At present the FTSE 250 is the largest weighting in the SLET portfolio (42.6%); this is because of a combination of more sustainable dividends and also some companies ‘growing up’: having previously been a non-index position, for instance, DFS (which recently paid a special dividend) is now in the mid-cap index.

As well as avoiding stocks that are vulnerable to dividend cuts, Moore’s approach allows him to respond after dividend cuts have taken place. Share prices of companies where the dividend outlook is poor tend to fall well in advance of a cut, but may stabilise once it has taken place. An example of this is Rio Tinto, which Moore bought back in February after it cut its dividend by 50%. He says the company has incorporated the weaker fundamental outlook into its dividend policy, showing it was facing up to reality, and it now has a higher yield than peers in the mining sector.

Looking ahead, Moore says the EU referendum is weighing on sentiment towards UK domestic stocks, but underlying prospects remain strong for companies in the portfolio, where dividend cover and growth are better than average. The manager argues that prices should move back in line with fundamentals once the Brexit uncertainty is out of the way (particularly if the UK votes to remain), and while capital values may fluctuate in the short term, dividend and earnings momentum are good.

SLET manager Thomas Moore is a member of Standard Life Investments’ well-resourced UK equity team and runs the trust using the firm’s Focus on Change investment process. Moore sits within the UK large-cap team, which provides full research coverage of the FTSE 350, and can also draw on the insights of the UK smaller companies team. SLI’s wider resource also includes quantitative analysts, risk management specialists and a large GSRI (governance, stewardship and responsible investment) team, as well as credit, real estate, multi-asset and strategy teams with whom Moore can discuss the macroeconomic backdrop. The trust’s portfolio is built from the bottom up, with company meetings forming a key part of the process.

SLI’s Focus on Change philosophy is centred on five key questions:

While not strictly a ‘value’ style, the aim is to buy stocks where the market has not appreciated the company’s potential, leading to the possibility of share price upside.

SLET has a large investment universe, encompassing not just the 350 largest UK stocks but also a further c 1,200 from the FTSE Small Cap, FTSE Fledgling and AIM indices. To narrow down the field, Moore uses SLI’s proprietary stock screening matrix, which looks at a range of measures including earnings revisions, EPS growth, director dealings, price momentum, valuation and yield. The trust portfolio has a bias to stocks with cheaper valuations and strong earnings and dividend growth. As well as using the matrix to generate investment ideas, Moore also applies it to the portfolio, with a deterioration in scores acting as a trigger to re-examine existing holdings.

The investment approach is unconstrained by FTSE All-Share Index weightings, although there is a 20% limit on non-index (broadly FTSE Fledgling and AIM) stocks. Moore aims to include only his best ideas in the portfolio of 50-70 stocks. Risk is monitored across the portfolio using SLI’s sophisticated factor risk tools, which measure risk both on an absolute level and in terms of divergence from the index position at the stock, sector and valuation level. SLI’s analysts give all stocks a ‘buy’, ‘hold’ or ‘sell’ rating. A downgrade to a ‘sell’ rating would usually cause Moore to exit a position; if a stock moves from a ‘buy’ to a ‘hold’ he will reassess the position. Given SLET’s aim to provide an above-average and growing income, a dividend freeze or cut would almost certainly be a trigger to sell a holding.

At 30 April 2016 there were 65 stocks in the SLET portfolio, with the top 10 making up 26.9% of the total. Seven of the top 10 stocks were also in the top 20 a year earlier, underlining the relatively low level of turnover (typically 30-35%, implying an average holding period of three years). Gearing was 13.2%; it is used to increase conviction in individual stocks rather than broadly across the portfolio.

The portfolio is broadly spread by market capitalisation, with 38.4% of assets in FTSE 100 companies, 42.6% in the FTSE 250, 5.4% in the FTSE Small Cap and 13.6% in non-index (FTSE Fledgling and AIM) stocks at 30 April. In sector terms the largest weighting is in financials, mainly insurance, real estate and asset managers, but with the recent addition of Lloyds Bank. The biggest change in sector weightings over the past year is an 8.6pp reduction in industrials, partly as a result of a reduction in the holding in packaging firm DS Smith, where manager Moore says the story is now well understood by the wider market. The largest underweights are to consumer goods, which Moore feels are expensive, and oil & gas, where dividends are under pressure as the oil price remains low. Financials, industrials and consumer services are the largest overweights.

The biggest overweight positions at 30 April were in software firm Sage (where Moore says the market has yet to appreciate the improvement potential given a new management team), BT, asset manager River & Mercantile (held mainly for its fiduciary services/institutional business) and Aviva.

Recent purchases include Lloyds Bank (the biggest net purchase of the past six months), Sage (topping up an existing holding), Investec, John Laing Group, International Airlines, ventilation specialist Volution Group (owner of the Vent-Axia brand) and Majestic Wines, recently the subject of a reverse takeover by Naked Wines, whose CEO Moore says is very highly regarded. Sales include BHP Billiton (following the Samarco dam disaster), Playtech (an online gaming company that announced a shift in strategy from B2B to B2C, where it has less experience), Barclays Bank (following a downgrade to guidance) and Cineworld. Moore sold out of Rio Tinto in late 2015 before it cut its dividend, and bought it back in February at a more favourable valuation.

SLET has a strong long-term record of outperforming the benchmark FTSE All-Share Index, as shown in Exhibits 4, 5 and 6, both under current manager Thomas Moore and his predecessor Karen Robertson. Positive share price returns over 12 months to 31 May (Exhibit 4), compared with a slightly negative NAV and benchmark total return, reflect the re-rating of investment trusts with UK smaller companies exposure in the aftermath of the May 2015 general election.

The manager describes the first half of SLET’s 2016 financial year (1 October to 31 March) as a period of two halves, with strong performance in the first three months turning negative from the start of the new calendar year. In relative terms, the continued outperformance of defensive consumer staples stocks and the resurgence in resources, both areas to which the trust is largely unexposed, have detracted. In absolute terms, the impact of Brexit fears on UK domestic stocks, to which the trust is heavily weighted, has also been negative. However, good individual stock performance has come from holdings such as Sage, Micro Focus and Rightmove.

Having widened significantly in the run-up to the May 2015 UK general election, when sentiment towards smaller companies (a significant weighting in the trust) was poor, SLET’s discount quickly reverted to its long-term range, broadly between a 4% discount and a 2% premium. At 2 June the shares stood at a 2.4% discount to cum-income NAV; this is wider than the one- and three-year averages (0.4% and 1.2% respectively) but broadly in line with the five-year average. SLET has the authority to buy back up to 14.99% or allot up to 10% of shares annually to manage a discount or a premium. In the past five-and-a-half financial years, 6.78m shares have been allotted (including those issued on the exercise of subscription shares) and no shares have been bought back.

SLET is a conventional investment trust. It currently has two classes of share: ordinary shares (44.7m in issue) and subscription shares (4.47m outstanding at H116), which have a final exercise date of 30 December 2016 and can be converted into ordinary shares at 320p on the last business day of June and December. In H116, 728,215 subscription shares were exercised, and a further 1m shares were issued at a premium in response to investor demand. The trust has a £30m bank lending facility with Scotiabank, implying a maximum potential gearing level of c 15%. On average £25m of the facility was drawn during H116, and at 30 April SLET had net gearing of 13.2%.

Standard Life Investments receives an annual management fee of 0.65% of total assets, charged 30% to revenue and 70% to capital. There is no performance fee, and at H116 ongoing charges stood at 0.94%.

SLET pays dividends quarterly, in March, June, September and December. Since 2016 it has published a dividend timetable giving investors visibility on payment dates. The trust aims to achieve real growth in both capital and income and has increased its annual dividend at a compound rate of 3.7% over the past five years compared with a compound annual CPI inflation rate of 1.9% over the same period. The FY15 dividend of 14.7p was 5.0% up on the prior year and was again fully covered by income. Two dividends have so far been declared for FY16, amounting to 6.8p (historically the fourth dividend has been set at a higher level than the first three). Based on the 2 June share price of 418.3p and the last four dividends, SLET currently yields 3.6%.

SLET is a member of the AIC’s UK Equity Income peer group. This is a large sector of 23 funds; Exhibit 8 shows the 14 with a market capitalisation above £175m. SLET is the smallest of this group. In NAV total return terms the trust is broadly average over one, three and five years and is also close to the average for risk-adjusted returns as measured by the Sharpe ratio over one and three years. Gearing and dividend yield are also broadly in line with averages. In a sector where several trusts are trading at a premium, SLET has one of the smallest discounts to NAV. Charges are a little above the sector average but SLET does not charge a performance fee.

SLET has five directors. Richard Burns (chairman since December 2014) joined the board in 2006. Josephine Dixon was appointed in 2011 and Mark White became a director in 2013. Jeremy Tigue joined the board in October 2014. Keith Percy, the longest-serving director (on the board since launch in 1991), will retire at the December 2016 AGM, and the board is currently seeking a replacement. The directors have backgrounds in investment management and accountancy.