Schroder Income Growth (SCF) aims to generate real income growth from a portfolio of primarily UK companies. Managed by Sue Noffke, who is supported by Matt Bennison and Andy Simpson, SCF typically consists of a portfolio of around 40 companies, selected without reference to any particular stylistic bias. The managers aim to ensure the majority of portfolio differentiation to the benchmark FTSE All-Share Index is driven by stock-specific factors.
Presently yielding c. 4.0% (as of 24/01/2020), SCF has successfully grown its dividend every year since launch, averaging growth of c. 5.4% p.a. over the past three years to the end of financial year 2019. At the same time, SCF has seen growth in its revenue reserves in recent years, with revenue reserve cover of 1.01x the 2019 dividend. In our view, this provides a strong cushion to help ensure dividends continue to grow in the near future.
Since Sue took over lead management of the trust in 2011, there has been a gradual but sustained repositioning in the investment strategy. There is now less of a focus on producing the maximum level of yield, with Sue instead looking to generate a superior yield relative to the benchmark index whilst also looking to ensure greater portfolio-level dividend growth.
Incorporating ESG considerations into the analytical approach, the managers of SCF are able to draw on significant internal resources, utilising various internal equity analytical teams as sources for idea generation. The trust typically invests in companies in the FTSE 350, but has the ability to invest in smaller companies and overseas; however, Sue and the team presently identify the UK market as highly attractively valued, and are nearly wholly invested in the UK.
This positivity on the market outlook is also reflected in the gearing, with c. 15% of net gearing in place as of 24/01/2020; this was sharply increased in Q1 2019 from having previously been c. 8% net geared. This has helped relative performance, which in turn has piqued wider interest in the trust, helping narrow the discount from over 9% six months ago to c. 0.8% (as of 24/01/2020).
Schroder Income Growth (SCF) continues to offer a slight yield premium to the FTSE All-Share Index, and the substantial level of revenue reserves should mean the trust is better positioned than the wider market to continue to grow income distributions. With index-level payout ratios elevated and dividend cover low, factors such as a rally in sterling could prove a headwind to dividend growth amongst the wider market, but the domestic tilt currently held in SCF should further insulate it from these effects; the converse is, of course, true and a substantial sterling sell-off would be a relative headwind to performance.
Generally speaking, SCF will likely see stronger relative returns if we see an environment of UK-relative economic outperformance, but an absence of a strong global reflationary cycle. The gearing in place should help the managers participate more fully in any market upside, but the current level of discount is at a level where, following strong relative performance in 2019, any mean-reversion in relative returns would likely be exacerbated by a widening discount.
|Strong track record of dividend growth, supported by a deep revenue reserve||Narrow discount is reflective of recent strong returns, and could be vulnerable to any setback|
|Access to a deep pool of analytical resources||Gearing can exacerbate the downside (as well as amplify the upside)|
|Trust structure well suited to low-turnover approach||Relatively high charges|
The Schroder Income Growth trust (SCF) aims to generate real growth in income from a concentrated portfolio of primarily UK companies. Managed by Sue Noffke, supported by Matt Bennison and Andy Simpson, the team eschew a focus on factor-specific investment and instead use a blended stylistic approach (albeit one which is cognisant of ESG considerations) which looks to identify companies where the market has mispriced their prospects. The team see themselves neither as ‘value’ investors nor ‘growth’ investors, which is reflected in the Morningstar-style analysis – with the portfolio currently relatively evenly spread between core, growth and value factors. The investment process emphasises a low-turnover approach, with average annual turnover of c. 17% p.a. in the five years to the end of 2018.
Since Sue took over lead management of SCF in 2011, the investment strategy has migrated away from a focus on generating a premium level of yield to the benchmark FTSE All-Share Index, and instead looks to balance present income generation with the ability to grow income distributions over time.
Individual positions are considered on their own merits, but at a portfolio level are balanced across a spectrum using a barbell approach. Sue and her team look to balance the portfolio between two yield polarities which encompasses both those companies with inferior yield but which are growing income distributions, and premium-yielding companies with sustainable dividends.
This will also include a minority allocation to companies falling somewhere in the middle of these parameters, but this will typically be a small proportion of the overall allocation. Accordingly, the largest positions are split between companies with high but sustainable yields, such as GlaxoSmithKline, BP and Shell, and others where a lower level of yield is currently being generated but where there is greater potential for dividend growth, such as Tesco.
top ten holdings
|holding||%||relative to index|
|Royal Dutch Shell||4.7||-2.8|
|Lloyds Banking Group||4.6||2.8|
|British American Tobacco||4.4||1.3|
|Legal & General||4.2||3.4|
Source: Schroders, as at 31/12/2019
Whilst the trust tends to operate with a relatively low tracking error to the benchmark, the focus of the team is very much on ensuring that active risk relative to the index is a function primarily of stock-specific factors. To this end they receive regular risk reports detailing the contribution to active risk of each position, and to what extent sector or stylistic factors (amongst others) are driving the relative return profile of the trust.
Stock selection is primarily undertaken on a bottom-up perspective, without reference or deference to particular investment ‘style’ considerations, but instead assessing each company in a manner the team deem best reflects the likely future pricing of the stock.
Idea generation comes from a variety of sources, with the team in particular seeking to utilise the significant internal resource available at Schroders. The internal UK equity team, encompassing a range of managers and analysts in addition to the team responsible for SCF, meets weekly, sharing ideas and analysis and providing updates on operational performance at various companies. Also present at these meetings are dedicated ESG analysts, who are able to offer insight from an ESG perspective on any stocks under discussion.
This can often generate ideas for further research, including further collaboration with other equity teams, who are often able to provide insights into the strength of a business relative to its global peers. To this end, the team will also participate in similar internal team meetings run by regional and global equity teams, which often offer insights into the operational environments for different industries and the relative prospects for companies within these sectors.
The SCF team themselves also hold portfolio-specific meetings twice weekly, reviewing the companies on their watchlist (with reference to new research and possible additions), current portfolio positioning, and considering possible alterations to the stocks held. These meetings serve to help assess current portfolio diversification, monitor the underlying holdings, and help ensure that a majority of relative risk continues to be derived from stock specific factors, ensuring they have not, as an output of their process, become overly exposed to any one outcome or stylistic consideration. These meetings also help ensure the trust remains appropriately positioned for its income generating objectives.
External meetings with company management are an important input to stock selection, with the team looking to meet the management of all FTSE 350 companies at least once a year. A meeting with company management is considered a prerequisite before investment, and regular meetings are held with the management of all stocks held.
Stocks are considered and valued on the basis of their existing and potential operational performance, measured against how the market is pricing the fundamental business. The approach to stock analysis is not prescriptive in following a set formula, but instead attempts to consider the factors relevant to a particular business, and to consider a range of scenarios and how this would impact the company operationally going forward, and what this would mean for shareholders. This includes a realistic ‘worst-case’ assessment, attempting to determine stock-specific downside risk.
In seeking to identify companies which have lower operational risk, the team look for high quality and transparency of accounts, with strong governance models that ensure management incentives are aligned with shareholders. Companies favoured by the team often enjoy barriers to entry which give them a competitive advantage, and will ordinarily have strong balance sheets which give businesses greater ability to reinvest internally and deal with exogenous disruptive threats.
As Sue and her team operate a reasonably low-turnover approach and prefer to hold exposure to a relatively low total number of holdings, the team aim to gradually integrate new stock ideas into the portfolio, and operate a watchlist for prospective candidates. Typically this watchlist comprises around 25 stocks which have attractive characteristics, but where the team are either looking for confirmation that an operational turnaround is gaining traction, or where they believe the stock is too richly valued for investment at this particular time.
Under the barbell yield approach mentioned above, the team have scope to also include turnaround stories such as Tesco. Whilst Tesco’s headline dividend yield of c. 3.3% is lower than that of the wider index, Sue and the team can foresee scope for continued growth in distributions driven by ongoing sales growth and strong free cash flow yields which can continue to underpin the dividend and help potentially fund share buy-back programmes. Previously the team had assessed Tesco as having over-expanded, and had identified that the level of profit margins the business had previously been operating were anomalous for a food retailer and leading to an uncompetitive pricing model at risk of competitive disruption.
In reaching this conclusion they compared Tesco’s operational model to the norm for similar companies in other countries, notably identifying that German food retailers such as Aldi operated with significantly lower profit margins. The introduction of a new management team at Tesco saw what Sue and the team deemed to be appropriate measures to effect sustainable change; having been satisfied that an operational turnaround was evident but was not yet reflected in the stock valuation, they initiated a position in December 2017 on the expectation that the cash flow being generated within the business would lead to the reinstatement of the dividend and enable it to grow strongly. Furthermore, they noted that the balance sheet had improved and that the acquisition of wholesaler Booker was being increasingly efficiently integrated into the wider business. The business continues to generate attractive levels of free cash flow, offering management the opportunity to return capital to shareholders through increased dividends and potentially share buybacks.
Through their twice-weekly team meetings, the team can ensure that they are appropriately balanced for the aims of the strategy across positions such as Tesco, and more traditional high-yielding positions such as GlaxoSmithKline (GSK). GSK offers a premium level of yield to the wider market which Sue and the team believe is likely to be sustained going forward. Furthermore, the team believe there are encouraging early signs that an overhaul of the R&D process is taking effect.
Looking forward the team are optimistic on the outlook for the UK market, noting that the market offers a near-unprecedented level of yield premium to the rest of the world. Having previously moved the gearing position higher or lower depending on their tactical outlook, the managers have reflected their positive outlook by increasing their level of tactical gearing; this has generally been gradually moving higher in recent years, but rose sharply in early 2019. Similarly, since mid-2018 SCF has increasingly included a higher level of exposure to domestic UK revenue generation (now standing at c. 40%, against an index level of c. 28%), whilst the near-record valuation premium attached to growth-factor stocks relative to value factor stocks in the UK is, in the team’s view, creating value opportunities.
Whilst Sue can invest up to 20% of SCF overseas, this part of the portfolio is presently only c. 1%, as she believes the UK market offers superior opportunities at present. Similarly, the team have historically had the ability to write short-dated call options on holdings within the portfolio, but have not done so for several years, as the reduced levels of volatility seen in equity markets has reduced the income that can be generated by doing so.
Schroder Income Growth currently (as of 24/01/2020) has net gearing of c. 15%. The managers have the option of applying gearing of up to 25% of assets via a revolving credit facility. Gearing levels are variable, and reflective of Sue and the team’s outlook for markets, as well as a reflection of the relative cost of borrowing against the return potential from income and growth.
SCF has had net gearing in place since 2012, but has tactically varied the level at which it is applied over this time. In early 2019 the team sharply increased the level of gearing, believing the UK market offered attractive absolute and relative opportunities and that there were incipient signs of international investors returning to a market which offered an almost unprecedented level of yield premium.
SCF under Sue Noffke’s tenure has delivered significant outperformance of the benchmark index (as represented by a passive investment product), with NAV and share price returns of c. 115% and c. 129% respectively over the period 01/07/2011–24/01/2020. This compares favourably with a return of c. 81% for the benchmark FTSE All-Share over the same period. Whilst share price returns are in excess of those generated by the wider sector over this period (with the Morningstar UK Equity Income sector seeing an average share price return of c. 121%), NAV returns have slightly lagged the c. 132% generated on average by the sector. However, this NAV performance is skewed; the figure represents an equal-weighted average level of NAV return. In the past 12 months to 24/01/2020, the c. £9m market cap British & American investment trust, a very small component of the broad sector, saw NAV returns of c. 98%, skewing the average significantly.
returns relative to benchmark and peers
As noted in the Portfolio section, the managers seek to ensure that a majority of risk relative to the index is derived from stock-specific factors, and thus ensure that SCF is not overly exposed to variations in the relative performance of different style characteristics within the UK market.
We can in the chart below that the managers have largely been successful in ensuring that style-considerations are not the dominant driver of returns. This chart shows the monthly NAV returns of SCF on a rolling 12-month basis relative to the wider market, and those of growth and value factor indices relative to the wider market.
Periods of value or growth outperformance are shown on the right of 0 the horizontal axis, whilst periods of growth outperformance are shown on the right. Periods where SCF outperformed the index are shown above 0 on the vertical axis, and vice versa. The absence of any notable correlation of data suggests factors have not been a significant determinant of relative returns.
rolling 12-month nav returns relative to market compared to growth- and value-factor returns relative to market
Source: Morningstar (31/12/2010-31/12/2019)
SCF generated NAV and share price returns of c. 23% and c. 29% respectively over the course of 2019; this compares favourably with a benchmark return of c. 19% over the same period. NAV returns lagged the sector-average NAV returns of c. 26% slightly (partially as a result of the outlier effect of the British & American Investment Trust, as noted above), but share price returns outperformed the sector average of c. 23%.
Overweight exposure to the mid-cap market generally benefitted relative returns, whilst the decision to increase gearing also proved beneficial in an environment where the wider market rallied. Similarly, moves throughout much of 2019 to increase exposure to companies generating their income domestically in the UK ultimately proved a boost to performance, as these areas rallied into the year end. Sector allocations we positive, as was stock selection, with overweight positions such as Pets At Home and Intermediate Capital Group notable contributors, though an overweight position in Pearson detracted.
2019 returns relative to indices and peers
With the migration in trust strategy (as discussed in the Portfolio section) focussing less on ensuring a premium level of yield to the index and instead looking to ensure growth in income as well, the variance in returns has fallen somewhat as well. In the chart below, we can see the relative returns of the SCF NAV returns relative to the benchmark have generally varied less from the benchmark FTSE All-Share Index than was previously the case.
SCF has a greater performance skew towards the relative fortunes of the large-cap sector than the wider peer group; this is in part a reflection of the premium yield and greater income focus. As such, periods of mid-cap outperformance have historically been somewhat of a headwind to the trust relative to the sector.
Relative returns over the previous 12 months have been notably strong, and the degree of outperformance may appear extended compared to the trust’s usual tracking error. However, a rise in active share and the tactical decision to increase gearing will have played a significant part in this, and as such a wider tracking error than has been the case for much of recent history is likely to be expected in the near future. We can see in this in the chart below, which shows the rolling 12-month returns relative to the benchmark and sector; having seen relative performance to the benchmark be relatively constrained for most of the past three years, 2019 saw notable NAV outperformance. As noted under the Discount section, discount narrowing or widening has often tended to track NAV-relative returns.
rolling 12-month relative returns
We can also see that SCF has tended to deliver stronger returns in periods where the market was positive; gearing has been in place on the trust throughout his period, and will have proven a headwind during periods of market drawdown. The weaker period for returns seen in 2016 was partially a result of underweight sector exposure to mining and commodity companies in a strongly reflationary macroeconomic environment, which saw this sector strongly outperform (though the managers did hold Rio Tinto). At the time the mining industry had notably high levels of excess capacity, and in an uncertain macro environment this would not have sat well with the focus on sustainability of dividends.
SCF shares currently yield c. 4.0% (as of 24/01/2020). The trust has a noteworthy history of dividend growth, having raised total annual dividends for every year since launch, a streak of 24 years of increased distributions. Over the past five years (financial year 2014 to financial year 2019), dividend growth has been comfortably in excess of inflation, with average growth of c. 4.2% p.a. compared to UK CPI growth of c. 0.8% over the same period. This has further accelerated to c. 5.4% p.a. over the past three years.
Whilst it was necessary to draw upon some revenue reserves in the immediate aftermath of the financial crisis to ensure growth in distributions, these have subsequently been replenished. In the reporting period to 31/08/2019, SCF held revenue reserves of c. £8.6m, representing revenue reserve cover of c. 1.01x.
The managers note that sterling weakness has been a tailwind to dividends in recent years, but that relative to the US dollar it is now trading near the bottom of its 40-year range. If previous weakness were to reverse, this could prove a headwind to index-level distributions, at a time when payout ratios are already extended. However, SCF’s overweight exposure to domestic revenue generation should help to mitigate this impact, whilst at the portfolio level we understand that the portfolio has a superior level of dividend cover to the benchmark index.
dividend per share
SCF is managed by lead manager Sue Noffke, the head of UK equities at Schroders. Sue joined Schroders 30 years ago and has been running UK equity portfolios for 26 of these years. She has formally been lead manager of the trust since July 2011 and heads the Prime UK Equity team. The team consists of herself (fund manager), Andy Simpson (fund manager), Matt Bennison (analyst/fund manager) and James Goodman (analyst).
Supporting the team are an abundance of in-house resources, including various regional and global equity teams and dedicated ESG analysts.
Schroder Income Growth currently trades on a slight discount of c. 0.8% (as of 24/01/2020), having seen a notable narrowing in the discount over the past 12 months as a result of share price outperformance of NAV, particularly in December 2019. The narrowing in the discount seen in H2 2019 was in line with a general improvement in sentiment towards UK equities, as observed in the general narrowing of discounts across the sector.
Whilst the board has the capacity to buyback or issue new shares if they deem it appropriate, they have not exercised this option in recent years. The shareholder register is wide, with few substantial share interests. With a relatively non-interventionist board, the discount is also more likely to be impacted by changes in wider market sentiment; historically this has seen the discount prove more volatile than that of the wider peer group. Any significant negative change in sentiment is likely to be felt in the discount widening.
discount/premium vs Nav-relative returns
Schroder Income Growth has an ongoing charges figure of 0.93% against a sector average of c. 0.61%. This includes a tiered management fee charged at a rate of 0.65% on the first £200m of assets and 0.55% per annum on subsequent amounts; we calculate the effective rate to be 0.63%, based on the net assets of £251.7m. This compares with the weighted peer group average of 0.61% according to JPMorgan Cazenove. The KID RIY is 1.72%, relative to a sector average of 1.24%, although we note that calculation methodologies can vary across the sector.
As discussed in the Portfolio section, ESG considerations are a notable input into the team’s qualitative analytical approach. This includes assessments of business management quality and governance are considered important inputs to the investment process, and engagement with companies is an ongoing process, both pre- and post-investment; this tends to lend itself to companies with strong sustainability and governance characteristics.
Schroders have significant ESG resources, including internally developed tools such as SustainEx and CONTEXT, which are used to analyse portfolios. The use of these tools are integrated into the stock analysis undertaken by the SCF team. CONTEXT assesses various facets of a business, such as employee treatment and retention, relationships with suppliers, community impact, brand perception, environmental considerations, governance issues, and how the company sits within the regulatory environment.
As an investment house, Schroders has a team of dedicated ESG analysts, who will be represented at equity team meetings to offer ESG perspectives and insights to potential investments.