Sam Benstead interviews Schroder Income manager Nick Kirrage about how he finds income winners in the UK market. He explains his “complete” income concept, where dividend yield, dividend growth and capital growth all play an important role.
He also reveals the three “P” shares he likes currently: Pennon, Page Group and Prudential.
Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Today our guest is Nick Kirrage, manager of the Schroder Income and Schroder Recovery funds. Nick, thank you very much for coming into our studio.
Nick Kirrage, manager of Schroder Income and Schroder Recovery funds: Thanks for having me, it’s a pleasure to be here.
Sam Benstead: So, let’s start with the Schroder Income fund. What do you look for when buying income shares?
Nick Kirrage: Great question. We’re thinking about the entire portfolio at the portfolio level. And when we talk about income, we talk about complete income. We want to produce three things from that portfolio. We want, first and foremost, a decent dividend yield, obviously. We want people to be able to live off these funds and we’re conscious that they do.
But we don’t want that to come at the expense of capital growth. Over time, the capital must grow, the shares must grow, because that allows you to pay out a bigger income – and that’s the third part. We want that income to grow over time. So, a growing dividend, those three elements, all three.
Now, when we’re trying to build that up, we don’t need every share in the portfolio to do all three of those things. But we do need every share in the portfolio to have an attractive valuation and to be cheap because that’s ultimately what drives up that net asset value (NAV) from which the yield and the dividend growth come. So that’s one inflexible bit that we make sure every share has, and then we try to balance yield today, so income today, with income growth for the future.
Sam Benstead: And the yield on the fund, what is it roughly at the moment?
Nick Kirrage: It’s somewhere around 4.5% today, which is quite high by historic standards both for the FTSE, for the market itself, but also for our fund.
We typically think it was more like 4% over the long term. I think probably the fact that it’s higher tells you about some of the attractive valuations that are in the UK market today and the attractive yields that are on offer.
Sam Benstead: Are you a very active investor? And can you give us some examples of some recent purchases for the fund?
Nick Kirrage: We’re very active, we’re accountable, but we don’t turn the portfolio in a particularly quick manner. We’re quite long term. On average, we’re holding shares for around five years, about 20% turnover. We’re long-term holders of these investments. It takes time for them to show us that growth.
You can get the yield quite often, quite quickly, but [for] the shares to improve and for that dividend to grow takes time. We’ve been looking at a number of different companies. It’s kind of well-talked about that the UK has some really attractive offerings in a global context.
I can think of the “three Ps” at the moment. So, Pennon Group (LSE:PNN), Prudential (LSE:PRU) and PageGroup (LSE:PAGE). So, three that are very different in terms of what they do: a utility, a financial company, and a staffing company, but all offer a constituent element of that complete income that we want.
We think, with a five-year investment horizon, have attractive attributes that even if things are difficult today, which can often be the case when you’re buying value investments, they’re cheap and some people would say cheap for a reason. We typically find those reasons, if you’re willing to take a five-year investment horizon, can abate, change or improve. And in those cases, we think that they are hopefully future drivers of return for the fund.
Sam Benstead: And what kind of yields are you getting on those three P shares right now?
Nick Kirrage: So, quite different across them. With Pennon, a utility, you’re getting quite a lot of the cash paid to you in hand in a nice, attractive yield, and we’re about to go into a new regulatory period. They’ve been very explicit about the cash you’re going to get there. So, somewhere between 5%-6% per annum will come out of that business.
For something like a Prudential, you’re getting a lower yield today, but there’s more growth coming to a business where there’s a big life insurance business, but it’s predominantly out in Asia. It’s been hit by all the poor macro news and concern around China and Asian markets. But actually these are businesses where you’re seeing that penetration of life insurance as…wealth in fact improves out in Asia, this is a thing that everyone takes on. It’s a savings product, it’s a long-term insurance product, and so you’re seeing that penetration. So, there’s more of a trade-off between the yield today and the growth.
With something like Page Group, that’s a more cyclical stock, and some people might say that’s strange to see that in an income fund. But what we see from these kind of businesses is, typically, because they’re cyclical, they can become very cheap at different points in the cycle. And also while their dividends are depressed in the short term, you get a lot of dividend growth as things improve over time.
One of the things that people really miss when they talk about dividend growth is that people tend to think about the kind of apocryphal example of a great business compounding, growing its dividend over time. But a very heavy element of the dividend in the UK market, comes from businesses that have historically cut their dividend coming back.
One of the huge examples of that in the last 18 months has been banking. Banking was nearly a quarter of all dividends prior to the great financial crisis in the 2008 period and then went to almost nothing overnight. Now we’re seeing very strong dividend growth as that comes back to market, and we want our income unit holders to be able to benefit from some of that growth. So, we invest in a number of those shares in those kinds of situations.
Sam Benstead: So, banking, an important sector. Which types of companies are you finding good value and good income in there?
Nick Kirrage: Well, banks themselves, I suppose, have done very well. Broadly, there’s kind of two franchises. There’s more retail-oriented banks, like a kind of NatWest Group (LSE:NWG) or a Lloyds Banking Group (LSE:LLOY), and then those that have more of an investment banking angle to them or an overseas angle. So, Barclays (LSE:BARC) would be a good example or a Standard Chartered (LSE:STAN) or an HSBC Holdings (LSE:HSBA). They have slightly different valuations. They’re all benefiting from that increase in interest rates that we’ve seen over the last two or three years. That’s allowing them to have a more balanced set of income streams, both from their lending, but also their deposit franchises.
A lot of that is getting locked in through a kind of structural hedge. They hedge this income over time so that it isn’t volatile year to year. At the moment, we’re locking a lot of that in at a higher rate. So, we believe it will stay longer and stronger, the generation of profits from those businesses and the income from those business.
They’ve also been buying back their shares, very cheap valuations. Actually, one of the things people miss about buying back shares is what that does for dividend per share growth. Very crudely, if you’re paying out the same amount of income, but it’s going over less shares, there is more income per share and you get good growth from that. People sometimes talk about the earnings per share effect, but we think about the income per-share effect and we’ve seen a great benefit.
They’ve done very well over the last 18 months and we have reduced some of those positions because, all else being equal, there’s not as much upside as there was and a lot of that income is being generated already, but we still think there’s a lot to go for and that banking remains a kind of cornerstone sector of our income fund.
Sam Benstead: Does a high dividend yield signal a failing company, or can you find great opportunities even though the dividend yield is very high?
Nick Kirrage: That’s a very, very good point. I think as yields get above the kind of 6%, 7%, 8%-type level, typically what you see if you look at the data over a very long period of time, the realised yield, so what you actually get, tends to not be anywhere near that and the higher it gets the harder…the real yield plateaus. The reason is because businesses that look optically like they have very high dividend yields, the market is telling you it doesn’t believe the yield will be paid, the dividend will be cut. And in many cases, the market’s right. It’s not foolish. So, actually the number that do pay and the level at which they do pay, things kind of start to level off.
Now, having said that, there are key examples where dividends continue to be paid at quite high levels. What we look at here is payout ratios. There is a difference between two businesses that have a 5% dividend yield if one is paying out all its profits, and the other is only paying out half its profits to achieve that. So, we look closely at that.
Some sectors pay out more, and there is less underlying growth in the market, so they return more to shareholders in the interim. It’s a more mature business, but the returns can still be very, very good. So, if we think about businesses like life insurance companies or tobacco today, businesses that have high dividend yields, but we think sustainable dividend yields, and actually they will be a larger proportion of the return our investors make over the long term. So, instead of it coming just from share price growth, more of it will come in cash in hand paid to you each year. But we believe those to be sustainable.
Sam Benstead: Are there cases when you’re happy to accept a lower yield because you think that’s a high-quality business?
Nick Kirrage: What’s really interesting is where you can buy those high-quality businesses, but you can buy them when people think they’re not high-quality businesses. So, a good example, a recent one with a more depressed dividend yield or very little dividend today, but one that we think is a high-quality franchise and will come back and pay a dividend over time is Burberry Group (LSE:BRBY), a luxury good, one that was beloved two or three years ago, and fell on hard times. We saw profits under a lot of pressure and it spooked everyone.
They’ve actually cut their dividend back in order to preserve the business and make sure that there’s no pressure there, and they have the time to restructure, to change, to grow again. But when we look at the historic levels of profits, we think that you can take a very conservative view on how achievable those are again in the future. You don’t have to assume high levels of growth, but these are quite high-returning businesses with decent profit margins over time. There’s no reason that business shouldn’t pay a pretty compelling dividend when it returns and comes back.
Businesses like that, there are a number of them in the market. In the short term, as an income fund unit holder, we could, or as an income fund manager, we could replace those businesses and put in businesses that yield more today to turbocharge the dividend yield today. We think that would come at the expense of the dividend growth in the future and the capital growth of the fund. So, we’re trying to balance these to get that kind of complete income to our unit holders.
Sam Benstead: Oil and tobacco shares feature in the portfolio. These are often regarded as ‘sin stocks’ but actually can be very good income investments. Why do you like these types of businesses?
Nick Kirrage: ‘Sin sector’ is really catchy, isn’t it, but I think what we’re learning a little bit about on the environmental, social and governance (ESG) journey we’ve been going on over 10 years, but specifically the last three or four years, is that these labels and tags can be a bit lazy and perhaps hide a more nuanced and balanced view.
The truth is that oil & gas we know on a 100-year view we’ve got to find an alternative and a solution and transition. That is absolutely known and we buy into that. But in the medium term, these are businesses that are required for that transition and hydrocarbons are needed. We need solutions to overcome some of the downsides, carbon capture and all the rest of it, and we need over time to replace those sources of energy with other sources of energy that are clean, whether they’re wind, solar, and we would probably argue a reasonable slug of nuclear or small modular reactor technology.
But in the interim, these are businesses that have a role to play, not only in producing the energy to make that transition and to invest in those other technologies, but also to transition themselves. We think that there is a future, they’re not stranded assets in those ways.
Tobacco, again, it’s a more complex argument and over time we do see that volumes are coming down there, that these are business that over time won’t exist on a 100-year view, or shouldn’t exist. But in the interim, we think they are quite cash generative. They’re huge contributors to the taxes that governments use to reinvest in healthcare and everything on the other side of the ledger.
While there are funds that would take an ethical view and say, our investors ask us not to invest in those sectors, and we’d be very comfortable doing that on behalf of our investors, for our income funds, we aren’t asked to do that. We’re asked to look at the broad spectrum of investable opportunities, and these have a role, or have had a role, in our portfolios in terms of meeting that income requirement.
Sam Benstead: The income fund is ahead of the FTSE All-Share over the past decade. What does this tell us about income investing as a way of accessing the UK market?
Nick Kirrage: I think income investing has always been evergreen. The reason that income investing tends to do well over the long term is because it’s a valuation approach and value investing has a very long history of outperforming the market. That actually happens for reasons that aren’t totally associated with the income, they’re associated with the psychology.
Because businesses that as their dividend yield goes up, what it’s kind of saying is that their share price is going down in many cases. And the share price tends to be falling for reasons that worry people, and when people are worried, they tend to sell shares without really looking too closely at the valuation because they just want to get out. It’s that loss aversion. Psychologically, we know we feel a loss as humans statistically twice as much as we feel the joy of a gain.
So, if we think things might be starting to go wrong, we tend to sell first and ask questions later, and that’s how these high yields appear in many cases. And why those stocks go on to do well is because when you sell shares without thinking about the cash in hand, without thinking about the valuation, or the return you might make, typically those shares go on to do well on average.
So, there is this causal link between the psychology, the investments, and value and income investing, which we think is pretty evergreen. It doesn’t rely on a certain macro scenario or on a political backdrop, or even on your view of UK GDP. There is a broader thing here, which is that you are effectively saying, do I believe that humans are going to continue to behave like humans? And if you believe that, then income investing remains an attractive way to invest money over the long term.
Sam Benstead: Finally, the question we ask all our guests, do you personally invest in the Schroder Income Fund?
Nick Kirrage: Much more money than I should and my family knows. But, yes, I believe very much in eating my own cooking. I think any fund manager who says they don’t invest in the way that they invest themselves, you should probably ask questions. And I think that’s right. But I believe this is a strategy for the long term.
Sam Benstead: Thank you very much for coming into the studio.
Nick Kirrage: Thanks for having me, Sam.
Sam Benstead: And that’s all we’ve got time for today. You can check out more Insider Interviews on our YouTube channel where you can like, comment, and subscribe. See you next time.
