Schroder Income Growth shows modest NAV underperformance

Schroder Income Growth (SCF) has announced its annual results for the year ended 31 August 2020, during which it provided modest NAV underperformance of its All-Share benchmark. Over the twelve months, SCF provided an NAV total return of -13.2% and a share price total return of -7.0% (during the year, the share price’s discount to NAV narrowed from 8.3% to 1.9%). The company says that, in comparison, the All-Share Index returned -12.6%.

25^th year of dividend increase, despite revenue income falling 16.3% due to COVID-19

SCF provided a total dividend distribution of 12.6p per share for the year. This 12.6p was 1.6% up over the previous year, thereby delivering the 25th year of consecutive increases. The increase is also higher than the 0.2% rise in the Consumer Price Index, enabling SCF to continue to meet its objective of providing real growth of income. SCF’s revenue income during the year fell by 16.3%, because of COVID-19’s impact on investee companies’ ability to pay dividends, so a small transfer was made from the reserves that SCF has built up from income in earlier years. SCF’s chairman, Bridget Guerin (pictured), says that these revenue reserves are now equivalent to 11 months of dividends, and these remain available to the trust support growth of income going forward.

Investment manager’s comments on portfolio performance

“The NAV total return underperformed the FTSE All-Share Index, as the portfolio’s gearing proved a disadvantage during the falling market.

Source: Schroders, 31 August 2020

Stock selection and sector allocation were positive. The portfolio entered 2020 more focused on domestic cyclical companies, which we believed were set to benefit as political risk around Brexit dissipated following the General Election and a rally in sterling. When the impact of the COVID-19 situation became apparent, we took decisive action early in the crisis regarding companies where we had particular concerns or where our original investment theses were jeopardised, as well as reducing the level of borrowings.

The portfolio benefited from moving underweight in the oil and gas sector, whilst reinvesting part of the proceeds in mining companies. Oil prices have fallen significantly in response to oversupply. However our decision was based on a view that companies were unlikely to be able to satisfy all stakeholders needs given their stretched balance sheets together with the transition to clean energy involving significant capital expenditure and likely acquisitions. Ultimately this transpired in the decision by Royal Dutch Shell and BP to rebase down their dividends. In addition the portfolio benefited from boosting its weightings in mining companies by buying Anglo American to add to Rio Tinto and BHP Billiton. The mining sector’s performance has been robust due to demand for commodities from Asia remaining strong as these economies have been first in and first out of the COVID-19 pandemic.

The portfolio benefited from selling out of all banks (including HSBC), while GP practice property business Assura and Legal & General have been strong performers. Pets at Home, which was classified as an essential retailer by the UK Government, benefited from spending on pets remaining resilient.

Five top/bottom relative performers

Source: Factset.

1Weights are averages over the period.

2Performance relative to the FTSE All-Share Index.

3Impact is the contribution to performance relative to the FTSE All-Share Index.

Certain cyclical domestic holdings weighed on performance, including Whitbread, and house-builder Crest Nicholson (sold from the portfolio after the year end), and we reduced these holdings, amongst others, as the scale of the pandemic became clear. Pearson detracted from performance after a profit warning last autumn driven by poor trading in its US university textbook business. Pearson have had a challenging few years of operational performance recently as earnings have been under pressure due to the decline of print textbook sales in the US higher education market. While we acknowledge the pressure from this, we believe there is a big opportunity for the company to create value from their digital education business.”

Investment manager’s comments on portfolio activity

“Turnover has been higher than in the past, as we took action in holdings where we had concerns or where the investment thesis was negated by COVID-19, and sought to reposition the portfolio as the outlook changed materially from what had been a benign economic background with reduced domestic political risk.

Last autumn we extended the positions in domestic UK stocks where we believed there to be an opportunity for valuations of these stocks to correct upwards on a resolution to Brexit. Purchases in Next and Royal Bank of Scotland (now Nat West) accompanied additions to Legal & General and Lloyds Bank, and were financed by reductions in HSBC and Royal Dutch Shell.

Between the general election and the pandemic we sold BT, where we felt the risks to the dividend and opportunities from accelerating the rollout of fibre broadband were fairly balanced. We established a new holding in National Grid. Political clarity in the UK sets the scene for the Company to deliver defensive earnings growth while opportunities should accrue from the decarbonisation of the economy. We also added to a number of defensive companies on attractive valuations, such as Unilever, RELX and BAT.

As the pandemic unrolled, we reassessed the investment theses of many of the holdings, selling the bank and oil holdings and several cyclical domestic companies such as ITV, Next, Taylor Wimpey, Crest Nicholson, and Whitbread. Proceeds were deployed to take advantage of capital and income opportunities, to support fund raisings and to invest in companies we considered better placed to recover more strongly, such as Anglo American, Direct Line Insurance, M&G and Prudential. We engaged constructively and frequently with many holdings to get reassurance on short term liquidity and understand the operational levers companies had at their disposal.

By the summer activity reverted to more normal levels. We sold out of speciality chemical company Johnson Matthey and established a new holding in business services supplier Bunzl.”

Investment manager’s comments on outlook

“COVID-19 is the quintessential exogenous shock. The range of potential outcomes appears very wide. This holds true for companies at both an operational level of profitability and their ability and desire to reward shareholders with dividends. On the positive side there is the potential for vaccination. Areas which would do best in such a scenario would be those that have been hardest hit – for example, banks and consumer discretionary sectors such as travel and leisure. On the negative side, it may take a long time. In such an outcome markets could fall as some expectation of a vaccine has been priced into markets. Areas which would hold up relatively well would be defensive growth companies with resilient balance sheets and franchises. In this instance COVID-19 may prove such a shock that some industries are permanently changed through overcapacity, technological changes or changes in consumer behaviour – e.g. airlines, cruises, and traditional retail/office companies (none of which are in your portfolio).

We remain bottom-up stock pickers looking for idiosyncratic investment opportunities. Macro events often throw up stock-specific opportunities and this has been the case during the height of the crisis. Our process incorporates scenario analysis to test both the upside potential and the downside risks. As we survey the opportunity set today, we feel that there are many attractive opportunities. We also believe that there is good reason to be optimistic about UK equities, not least because sentiment remains so poor. The uncertainties are well known but the positive long-term prospects of many businesses have been obscured by gloomy headlines on COVID-19 and Brexit alongside high-profile dividend cuts.

Notwithstanding the high levels of uncertainty, there has been a resumption of bid interest from overseas buyers as companies seek to take advantage of cheap prices, low financing costs and an attractive exchange rate. We also note the appearance of activist investors. Two holdings – G4S and William Hill – have been subject to takeover approaches since the end of August, with both shares rising sharply.

We believe that income in the current financial year will be somewhat lower than 2020 as we have yet to pass the anniversary of COVID-19, which coincides with the declaration of many companies’ final dividends. It remains important to balance the sources of income as well as to look at a time horizon beyond the immediate. The portfolio includes many companies that continued to pay dividends and companies where the pandemic disrupted payments but where we see the ability for payments to resume. It includes low but secure yielding stocks, typically from defensive and growth areas such as essential retailers, specialty property stocks with secure tenants, and business-to-business services companies with secure revenues.

These are balanced with higher-yielding shares where the work we have done gives us comfort that dividends are sustainable, such as mining, insurance and investment companies. The stocks with takeover bids, G4S and William Hill, are examples of those retained despite not paying dividends. Where appropriate, a number of companies have also resumed the payment of dividends deferred in the spring, such as defence company BAE, Direct Line Insurance and Bunzl. We believe that this barbell approach will provide a good level of income and investment style diversification in order to meet income and capital growth objectives over time.

Our work on portfolio companies reassures us about the attractive absolute and relative value in the portfolio. We remain positive on the prospects and believe that retaining gearing at the current low level of markets is appropriate for two reasons. Firstly, given the low costs of borrowing, the extra dividends benefit portfolio income. Secondly, investors will be rewarded over the longer term by the boost to capital returns of market rises from the current low levels.”

Investment manager’s comments on investment policy

“We are sticking to our disciplined investment process that has served us well for over 20 years, and look to take advantage of opportunities in market-leading, cash generative, well-managed businesses which trade at attractive levels. We continue to work closely with our in-house analysts to help identify attractive potential investment candidates and to monitor the validity of the case for existing holdings.

Five largest overweight stocks

Source: Schroders, as at 31 August 2020.

We continue to believe that an actively managed portfolio with a bottom-up, stock-specific focus can deliver on the Fund’s capital and income objectives. The uncertainties are well known but the long-term prospects of many businesses have been obscured by the headlines on COVID-19 and Brexit alongside high-profile dividend cuts. By taking a measured, long-term investment view, we believe that the portfolio will be able to exploit the many mispriced bottom-up stock opportunities in the market.”

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