The Man GLG Income fund, managed by Henry Dixon, aims to provide a dividend yield well in excess of the FTSE All-Share index, as well as paying a monthly income. In this interview, Dixon runs through how he assesses the sustainability of a dividend to avoid potential ‘value traps’, names a couple of high-yielding shares he’s backing, and explains how he factors in capital growth when sizing up dividend stocks.
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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Henry Dixon, fund manager of the Man GLG Income fund. Henry, thanks for your time today.
Henry Dixon, fund manager of the Man GLG Income fund: Thank you for having me.
Kyle Caldwell: So Henry, to start with, could you explain how you invest and what the fund is seeking to achieve?
Henry Dixon: Absolutely. So, if we start off with the objective of the fund, we're certainly aware of the need to beat the FTSE All-Share index over a period of time. But I also think, crucially, provide a yield well in excess of the FTSE All-Share, and the yield point is important, and what maybe sets the fund slightly [apart from] other funds is the monthly dividend, which has been very well received from the investor base. If I think how we go about trying to do that, I would highlight three types of opportunities that we look to invest in.
The first is businesses below replacement costs. Invariably, that can be quite a contrarian portion of the market, but you're looking for lots of asset value, definitely in a sector that will probably be out of favour at the time when you take the investment. But if you can line it up with a good balance sheet and cash flows that can weather the storm, and the cycle can turn, that can actually be a very rewarding part of the portfolio.
A second element of the fund is where we see returns on capital that are just mispriced relative to the capital base and the market cap. Finally, we like to have a portion of the portfolio where we have free cash flow yield above the market average, a net cash balance sheet, and that can typically drive quite attractive dividend growth, which can hopefully also be well rewarded with regards to capital upside.
Kyle Caldwell: So, for those three areas of the portfolio that you mentioned, could you name a stock example for each?
Henry Dixon: Yes, absolutely. So let's think about low replacement cost, a recent addition. We think about a company called Anglo American (LSE:AAL), a miner. Shares have been quite weak now, but for the prevailing price relative to their asset base, there would be absolutely no chance of replicating that asset base for the current price in the screen. Why is it here and below that asset base? Well, it's clearly concerns around China [and] how that's playing out. But with the shares now down about 30% this year, that looked like a really good opportunity to be taking advantage of.
If I think about shares where there are healthy returns on capital, [shares] that aren't being priced appropriately by the market, I might come on something like HSBC Holdings (LSE:HSBA), a big constituent of the market for sure but there was a very important catalyst last year with regards to the sale of their Canadian operations. They managed to sell a very decent portion of their business for well above book value. But the business in aggregate was trading below asset value, and you had a clear catalyst for that excess capital to be returned to shareholders. That was also quite an important decision last year and ultimately a very profitable one.
Finally, I might also think about the business with lots of cash on [its] balance sheet, [and] the opportunity for dividend growth. It's a business called Centrica (LSE:CNA). It has had a very tough decade. But I think what we saw last year was the competitive landscape transformed quite materially. The balance sheet became net cash, they returned to the dividend list, and the valuation [is] incredibly modest. Still in many ways perceptions [are] suffering from the scar tissue of the last decade, three/four times earnings. So, we had a really good combination of earnings momentum, very low valuation and a very strong balance sheet.
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Kyle Caldwell: The fund has a dividend yield of over 5%, which is higher than most of your peers in the UK equity income sector. To achieve that yield, how do you strike an appropriate balance between looking for high income and looking for capital growth as well?
Henry Dixon: I think it's a really important question. I think high income is not enough, high and static income certainly is not enough. The events of the last two years have proved that with the return of interest rates. So, what I'd say is in every instance, we absolutely don't neglect the importance of capital growth in every investment decision that we make. I think that's absolutely vital and a very good way of trying to grow income over a period of time is clearly to try to do with more capital, so that brings the capital growth element into it very importantly.
The other aspect with regards to dividend growth is if you, very importantly, operate under a proviso of conservative balance sheets, but also an environment whereby free cash flow yields are in excess of a dividend yield, so you have that headroom in which to grow. If you can marry up those two elements of value, and then also within that excess free cash flow that allows dividend growth, then I think you have a really good chance of growing capital and income through the cycle.
Kyle Caldwell: Could you name a couple of the highest yields and stocks in the fund today [where] presumably you think the dividends are sustainable going forward?
Henry Dixon: Yes, absolutely. I'll probably give you two or three because invariably when stocks attract a high income, there's a feeling about risks being cut and you've got to try to traverse that line of high yields that aren't cut, absolutely. But if I give you two or three examples of companies with a high yield in the fund, I guess one of the highest yielding is an onshore gas company in America called Diversified Energy Co (LSE:DEC). We actually [took part] in the IPO in 2017, and the shares have slightly more than doubled since then. The income from that company has risen about fourfold in the six years they've been listed, so it's very good dividend growth. But today it's on a dividend yield of 15%, so clearly question marks [are] emerging around the sustainability of it. And certainly it's a business model that has relied on debt, and clearly we now have higher interest rates.
So, how do we feel about the risk to the dividend in a higher interest rate environment? Well, I'd say two things. First, the company has done quite well with regards to turning out its debt profile. I think that's important. And then also they very much hedge their operations and de-risk their operations. And what I mean by that is they've got very good visibility on the gas price for the next two years, and they've also got a very low operating cost base. Being onshore in a place such as America means you are probably one of the most competitive producers of gas anywhere in the world. So that gives us confidence there.
Another area of high yield at the moment would certainly be banks. It's a very emotive subject, but I think they've corrected a lot of the issues, probably with business models that we saw 15 years ago. But it's quite typical to get double-digit yields out of banks at the moment. The combination of dividends, [and] also buybacks, but I'd highlight HSBC; that's also going to give a special dividend to investors in the wake of the sale of their operation last year.
And then, finally, a business I think investors might know quite well, Imperial Brands (LSE:IMB), that will be a yield [that is the] best part of 9%, also complemented by a buyback. So again, we're looking at total returns of over 10%. But certainly if I look at Imperial Brands, we don't own the other tobacco share in the market at the moment, British American Tobacco, the reason we prefer Imperial Brands is a better free cash flow yield, better working capital management now, a much better valuation, and also, critically, a much better balance sheet. So, it's that excess free cash flow yield, [and] sector-leading balance sheet, that gives us confidence. But you're absolutely right to push on these high-yield shares because these are the areas of the biggest reward and clearly some of the biggest risk.
Kyle Caldwell: And when you're assessing the sustainability of a dividend, when there's a high-yielding share, how are you avoiding the potential value traps? Are there any red flags you look out for?
Henry Dixon: Value traps are just such a painful part of the job and you do everything you can to insulate yourself from that. If we look at probably a couple of the value traps in the last year in the market, we've managed not to own them. Let's look at something like Vodafone Group (LSE:VOD), cut the dividend, it's a weak share price. I think, again, another dividend stalwart, or what was deemed to be, would have been a car insurer such as Direct Line Insurance Group (LSE:DLG). Again, cut the dividend to zero. So, these are very damaging events. And you try and work out a common theme of value traps and what happens. I mean, definitely I would observe that, financial leverage can certainly get in the way of realising the value that might be on offer.
If you look at something like Direct Line and compare it against another competitor Admiral Group (LSE:ADM). Admiral have a miles better balance sheet, and haven't cut the dividend in the way that Direct Line has. So it's that dividend element that is important. And also, again, if I look at something like Vodafone, further to high starting leverage, you have quite a bit of capital intensity. So it's really important that you think about cash flow trends, so there's clearly desire to invest, requirement to invest. That can be very expensive. And also working capital trends that can really obscure cash flows. So those would be two really important elements we try to screen out. And then the other thing with regards to value traps is I think about structural threat. And there might be parts of the media at the moment that are certainly facing some quite strong structural pressures. And typically structural pressures will require companies to invest.
And again, I think it's that level of investment that can obscure the cash flow. You can suddenly see a huge mismatch between cash earnings and stated earnings. So, I might highlight something like ITV (LSE:ITV), for example, which [has] definitely sort of fallen into that trap of being viewed as a value trap. But if you look at the mismatch of cash earnings versus stated earnings, then I think the story is quite clear.
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Kyle Caldwell: You mentioned earlier that the fund pays a monthly dividend, which sets it apart from competitors. Does that make it harder to manage the fund? Do you have to take into account when dividends are being paid throughout the year to have a certain amount of income coming in each month?
Henry Dixon: Certainly. We do a lot of dividend analysis on time in quantum when it comes in, although I think the key thing that encouraged us to make the decision to move to monthly was actually the year end of the fund, which is February. And, because it's a unit trust, not an investment trust, you have to pay out all income in year, although you can smooth the income flow within the year. But if you look at the cycle of dividends from the market, the very rich part of dividend collection happens in March and April. So, despite the fact that we hit the ground running with no dividends in the tank on 1 March, it's those months in March and April that allow us to accumulate quite a bit of income. And what we like to do for our investors is provide them with a forecast for the flat payments they're going to get throughout the year. And typically they get a little bit more at the end of the year. So I'd say it's a combination, I'd say the luck of maybe the February year end, but also just in general, the value on offer [from the UK market], which is one of the higher-yielding markets globally.
Kyle Caldwell: Henry, thanks for coming in today.
Henry Dixon: Thank you, Kyle.
Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interviews on our YouTube channel where you can like and subscribe. Hopefully, see you next time.
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