The drivers behind ‘hidden’ dividend hero’s outperformance

Law Debenture is a ‘hidden’ dividend hero, having maintained or increased its dividend for 45 years. Manager James Henderson explains the investment approach, how it has delivered strong performance, particularly over five and 10 years, and explains how building a position in Rolls-Royce Holdings (LSE:RR.) paid off.

Henderson also shares his top investment lesson since he was first involved in the management of Law Debenture Corporation Ord (LSE:LWDB) in 1994, and explains why he’s looking to increase exposure to European shares as part of the overseas allocation.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me James Henderson, manager of Law Debenture. James, thank you for coming in today.

James Henderson, manager of Law Debenture: Thank you.

Kyle Caldwell: So, Law Debenture, it’s classed by the Association of Investment Companies (AIC), which is the trade body for the investment trust industry, as a ‘next generation dividend hero’, with 15 years of consecutive dividend increases.

However, when you factor in both growing and maintaining the dividend, I know that Law Debenture actually has a longer track record of 45 years, which arguably makes it a ‘hidden dividend hero’. So, how sustainable is Law Debenture’s dividend over the next couple of years?

James Henderson: There’s two parts to the business. There’s the professional services business and the portfolio that Laura and I run.

The portfolio has a slightly sub-market yield at the moment and that gives more confidence that the dividend can grow. These companies are yielding a bit less and we believe they’ll grow their dividend more.

One of the features of the UK market in recent years has been the paying down of debt by companies. Balance sheets are stronger than usual, and companies’ dividend cover, i.e. the earnings cover of the dividend, is high. Those give you a lot of reassurance that the dividend growth will come through, as well as the professional services business, a third [of the dividend] comes from this professional services’ business. This is a good, cash-generative business that’s growing in the 5% to 10% earnings range at the moment.

So, that comes through with its cash, the portfolio is placed to have dividend growth because it’s not stretched in any way, the companies aren’t stretched to pay the dividends they’re paying. So, those are the ingredients for sustainable dividend growth.

I would just say one thing on this, that the privilege about Law Debenture is that we’re not stretched for dividend. We’re able to buy low-yielding shares or zero-yielding shares that will be returning to the dividend list, and this adds to the ability to grow the dividend.

I think where you try too hard to be a dividend hero, you can start to get yourself into fewer and fewer stocks, and we will be holding companies in this income fund that other income funds aren’t holding because we’re not constrained in that way.

So, hopefully that should help towards better capital growth. Better capital growth is what produces sustainable dividend growth. If you grow the capital, you’ve got more capital to produce the income over time.

For me, the funny thing about income funds is think first and foremost about growing the capital, and the income will follow. If you think about income first, you bleed the pot, you bleed the capital, and you don’t get the sustainable income in time.

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Kyle Caldwell: Law Debenture has a strong performance track record, particularly over the past five and 10 years. What have been the key performance drivers for the investment trust’s outperformance?

James Henderson: It’s been a large variety of different companies. There’s been no sector or company, and I like that - I like to see performance come from different places.

The standout share individually that would have contributed a meaningful, but not a huge, amount would be Rolls-Royce. We bought that at the time of its rights issue, and it has run up substantially from that rescue rights issue, and we have reduced it.

What else has helped? It has been the industrials. One of the privileges of running Law Debenture is the closed-end structure and a very bold board. During the Covid year, we were net buyers and that was something you couldn’t do in the open-ended funds because you didn’t know about your redemptions. You weren’t sure if you could buy because a lot of companies were cutting their dividends.

It was a period of uncertainty, but we were in a position to be able to buy and we geared the portfolio up more in that 2020 year and that has actually been a help in the years that have gone from then because we had bought at good levels during that 2020 period.

Kyle Caldwell: You mentioned Rolls-Royce. Could you explain your thought process that led you to buy Rolls-Royce and hold the stock when it had its rights issue?

James Henderson: There was a great business in there that was trying to get out. The previous management teams had done very well developing the Trent engine. Yes, they weren’t seeing the cash returns, but the actual product and what they had done, and the achievements were very large in an operational sense.

Therefore, when you bring different management, and a bit more cash generation into it, a bit of focus on a few different things, that then falls through.  But the business was there.

It is a great company, and it was seeing that that could perhaps come through was what got us buying. The turnover was there, they were one of the two suppliers to Boeing on the 727. It was going to happen if they could just get a bit more focus on the cash.

Kyle Caldwell: In terms of when you bought it, did you buy it during the rights issue, or did you own it before?

James Henderson: Yes, I had some earlier. I often find that things you own a small amount of, you focus on and you suddenly realise, you’re following them, you realise the opportunity there.

So, no, we didn’t start from a blank sheet of paper and buy them at the rights issue. I had a small holding before that, that we were losing money on. But that got me visiting the company and got me enthused about what was actually happening there and then we stepped up and bought more stock.

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Kyle Caldwell: As you explained in part one of our video interview, which viewers can watch here, Law Debenture predominantly invests in UK companies, but you also have some exposure to overseas firms. Could you explain what this part of the portfolio adds and provide some stock examples?

James Henderson: Yes, we have things there that we can’t find in the UK. So, there’s Toyota Motor Corp ADR (NYSE:TM), for instance.

There’s no big motor manufacturer in the UK anymore, sadly. We’ve got General Motors Co (NYSE:GM) as well. This is an industry that will be growing over time. It is an industry where there’s no exposure in the UK.

In turn, we’ve had Microsoft Corp (NASDAQ:MSFT) and Apple Inc (NASDAQ:AAPL) in the portfolio. Again, because there’s no Apple in the UK. We’ve sold both now.

Applied Materials Inc (NASDAQ:AMAT), another great American company, has been in the portfolio, and will come back into the portfolio when there’s a proper setback in the States sometime. So, we go to the States for these great companies when they’re perhaps less in favour than they are at the moment.

I think our next move overseas will be more in Europe. We’ve got about 5% in Europe at the moment. I think there will be a pick up in European, German, economic activity two or three years out. We need to start to position for that and buy some of the great German industrial companies.

I’ve just bought some in Phinia Inc (NYSE:PHIN) the other day for instance and we could well add to that holding. I think what you’ll see is a cyclical uptick in automotive in a year or two’s time. They make the sensors and there will be more sensors in the car. Those two factors coming together will lead to top-line growth and margin expansion, and that is attractive.

At the moment, people are very down on Germany. This is an opportunity.

Kyle Caldwell: You’ve just spoken about Europe being a potential opportunity that you’re looking into. Europe is unloved, but so’s the UK, and that’s despite the FTSE 100 index having a very good run recently and surpassing 9,000 points for the first time. Does the rally have further legs, or is a pullback potentially on the cards? Have some of those larger companies become too expensive?

James Henderson: It’s relatively more expensive than it was, you’re absolutely right. The market’s up 20% odd in the last year and it’s predominantly in the bigger companies. So, something like the banks, we were holding well below book. Now they’re closer or sometimes over book. We are actually reducing them a bit and buying further down the market cap scale. But they’re not expensive, the banks. They’re just not as cheap as they were, so that’s why we’re reducing.

So, you’re right, but it’s early days in this rally to be honest, in my view, in much of the UK, and it’s wrong to sell too much too early. You can just reduce a bit. If they make the kind of returns on capital, for instance, the banks that they could make over the next few years, they should trade at a premium to book. And we’re beginning to see but that’s not fully priced in yet.

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Kyle Caldwell: You’ve managed money through multiple market cycles. You’ve been involved in the management of Law Debenture since 1994. What would you say is the top investment lesson that you’ve learned in your career?

James Henderson: Don’t get overly excited and don’t get overly worried. It’s never as good as you’re told, and it’s usually not as bad as you’re told either.

So, we rotate from the popular to the less popular. And don’t worry if you do it a bit too early. It’s much better than doing it too late. So, sell into those big upswings and buy into the downswings.

Kyle Caldwell: In terms of the next couple of years, is there a particular sector or types of company that you would pick out as the best opportunity that’s exciting you at the moment?

James Henderson: Yes, I think the manufacturing industry in the UK has - what there is of it - some very, very good companies. There will be more success stories like Rolls-Royce coming out of UK manufacturing, and we’re looking for them.

Kyle Caldwell: Finally, James, a question we ask all fund managers we interview: do you have skin in the game?

James Henderson: Yes, I’ve actually just done some tax planning and given my shares to my children, but under the proviso that they don’t sell them.

So, I did build up a holding. As you say, I have been doing it for quite a long time. I have built up a holding gradually over a long time and now I’ve given most of them away.

One, it will keep me working hard because I haven’t got the shares there. Two, they’ll be quite tough taskmasters to me, the children, telling me they want to see better performance.

Kyle Caldwell: James, thank you for your time today.

James Henderson: Thank you very much, I much enjoyed it.

Kyle Caldwell: So, that’s it for our latest Insider Interview. I hope you’ve enjoyed it. You can let us know what you think, you can comment. And for more videos in our series, do hit the subscribe button and also hit that like button. Hopefully I’ll see you again next time.