Interactive Investor

How we find high-quality shares that deliver resilient income

Rebecca Maclean, co-fund manager of Dunedin Income Growth, makes the case for one of the highest-yielding firms in the portfolio, and explains the benefits of having up to 25% of the portfolio in overseas stocks.

12th March 2024 09:06

by Kyle Caldwell from interactive investor

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Our collectives editor Kyle Caldwell puts the questions to Rebecca Maclean, co-fund manager of Dunedin Income Growth Ord (LSE:DIG) Investment trust. One of the UK’s oldest investment trusts, last year it celebrated its 150th anniversary.

The trust has a sustainability focus and avoids certain “sin” stocks and sectors, such as tobacco. While some sinner areas of the market tend to have high yields, this has not impacted Dunedin Income Growth’s ability to pay an attractive level of income (with its dividend yield just under 5%).

Maclean explains how this is achieved through looking for “quality companies” that are paying “resilient income”. She also make the investment case for one of the highest-yielding companies in the portfolio, and explains the benefits of having up to 25% of the portfolio in overseas stocks.

Maclean says the trust is in a healthy position to continue paying a sustainable dividend. It has either held or grown its dividend for the past 43 years.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio, Im joined by Rebecca Maclean, co-fund manager of the Dunedin Income Growth Investment trust. Rebecca, thank you for your time today. 

Rebecca Maclean, co-fund manager of Dunedin Income Growth Investment trust: Its a pleasure to be here. 

Kyle Caldwell: So, Rebecca, could you first explain how the investment trust invests? It is predominantly focused on the UK, and the aim is to deliver both income growth and capital growth. So, how do you achieve those objectives? 

Rebecca Maclean: Sure. Last year Dunedin Income Growth celebrated its 150th anniversary, so its been around for a long time. But, while the underlying assets have changed from that time, when [the trust] started, it was investing in the emerging markets of the United States. But now, as you say, we are investing in the UK and in European companies.

I co-manage the portfolio with Ben Ritchie and the objective is consistent. It remains the same, which is to deliver an attractive total return and a growing dividend to shareholders of the trust. So, there are sort of four principles.

The first is that were looking to build a concentrated portfolio of our best ideas, so we currently have 36 holdings in the portfolio. Were looking for an attractive total return, so were not just buying high-yielding companies. Were looking for companies that we think can deliver dividend growth, and also capital growth too. And we do this by investing in quality companies. We are looking for resilient income too. So, were looking for companies where their dividends arent necessarily linked to an economic cycle or commodity prices. And, finally, we have a sustainable investing approach too, which does make the trust differentiated in the market. 

Kyle Caldwell: And how do you strike the right balance between delivering growth and income? I noticed Games Workshop Group (LSE:GAW) among your top 20 investments. It does pay a dividend, but some investors would associate it as being more of a growth stock. So, do you have some exposure to growth companies with low dividend yields, or in some cases, ones that dont pay dividends? 

Rebecca Maclean: Its an interesting example. So, we are looking for an attractive total return. And we think the best way to do that is to invest in companies which are high-quality and sustainable, ones we think can grow through the cycle. So Games Workshop is a good example. So its a £3 billion market cap company, it has grown its dividend more than 20% over the last five years, and its dividend yield is at a premium to the market, so it is giving us those attractive qualities from an income perspective.

Then from a quality perspective, its in a very strong position. Its got a high level of IP, a strong competitive moat. Its got a loyal customer base, which is growing, and [its a] strong operator as well. So theyve got vertical integration, theyve been investing in their marketing, and have been seeing a return on that investment too. And so this all supports the companys ability to grow earnings, and then that supports the dividend growth too for the company. 

Kyle Caldwell: The investment trust has a sustainability approach. Could you summarise it? 

Rebecca Maclean: We see sustainability as going hand in hand with quality investing. So, its part of our understanding of the quality of a business, how a company is managing those long-term environmental, social and governance factors (ESG) that are facing it. So, we do the approach in a number of ways. We have a negative screen which is applied to the portfolio, which reduces the trusts exposure to those sectors and businesses which are really facing the highest risks. So, tobacco and defence would be examples. But the policy is not really primarily about exclusions. It's much more about understanding how a companys managing its risks, and also how its capturing opportunities.

So, we have a sustainable rationale for every company in the portfolio. We look at the companies as being either leaders, and these are companies which have got best-in-class operational practices, when it comes to managing ESG factors, or they have products and services which address some of the most pressing societal or environmental challenges that we see.

And so those leaders, we see their sustainable profile as being supportive of the future returns of the business. But in addition, we also have companies which we see as improvers, which are companies that you may not think of as being necessarily sustainable. They won't be in most sustainable funds, but we think that through our analysis of the companies performance and their improvement, we think they've got positive momentum when it comes to managing these issues and, over time, they can be seen as future leaders. 

Kyle Caldwell: Could you give us an example of a company that fits into that category? 

Rebecca Maclean: We do have a TotalEnergies SE (EURONEXT:TTE) in the portfolio. It is the only oil and gas company that we have. And the reason is that we see that the company, on a relative basis, is very committed to a transition towards low-carbon energy. It invests a third of its CapEx in low carbon. And its messaging around this has been very consistent, whereas weve seen other large integrated oil and gas companies step back on some of their commitments. But we see that Total is a leader relatively and that over time, you should see that portfolio start to transition. And, as long as the returns remain attractive, then we think that will be positive for the investment case. 

Kyle Caldwell: The investment trust's dividend yield is around 5%. How is that achieved given that the “sinner” sectors, such as tobacco, that you do not invest in due to your sustainability mandate, have high yields? 

Rebecca Maclean: The trust has got a dividend yield of about 5%, which as you say, is at a premium to the market. The main reason for this is that the trust is trading at a discount to NAV. And we do write options on the portfolio to generate an additional 5%-10% of income a year. So, on an underlying basis, the portfolio has a similar yield to the market.

However, the way that weve constructed the portfolio is that were looking to have a diverse set of resilient income-paying companies. So, the challenge with the UK market is that it has got a premium dividend yield to other markets, but theyre very concentrated in some rather cyclical sectors. For example, 50% of the dividends of the UK market are in banks, oil and gas, and mining sectors, which are sensitive to economic cycles. And their dividends can be a function of commodity prices, for example, which means that they do fluctuate over time. We are underweight those sectors because we're looking to have that ability to pay a consistent dividend, which is going to grow over time. And we think it's better to look at the more quality companies, which are less economically sensitive to achieve that objective. 

Kyle Caldwell: And could you give us some examples of companies that have among the highest yields in the portfolio and whether you think that those dividend yields are sustainable? 

Rebecca Maclean: Assura (LSE:AGR) is one of the high-yielding companies in the portfolio. Its a healthcare real-estate company. It is supporting and partnering with more than 600 GP practices and treatment centres across the UK, and about five million customers or patients go through their doors on an annual basis. So, they really are sort of integral to society and supporting the NHS, which we know, requires investment, expansion and sort of being updated too, but it means that the revenues of the underlying companies in the portfolio are relatively resilient because these are sort of government revenues. And so that should support the ability of the company to pay its dividend, which is a high single-digit dividend yield. 

Kyle Caldwell: The investment trust predominantly invests in the UK, but theres also some exposure to overseas, where you can hold up to 25%. Could you explain the benefits of this exposure? 

Rebecca Maclean: There are a number of benefits for investing overseas. On the one hand it expands our opportunity set, so it more than triples the number of companies we're going to be looking at to be able to select those companies which we feel have the sufficient quality and sustainability characteristics, and the dividend growth, which we're looking for.

But it also means that were able to get exposure to unique businesses, markets and segments which you cant get exposure to in the UK. For example, one company that we have in the trust is Mercedes-Benz Group AG (XETRA:MBG). There arent many auto companies or ways to play the auto sector in the UK. But in Mercedes-Benz you've got a company which has a very valuable brand. An independent consultancy rated the Mercedes-Benz brands the seventh-most valuable brand globally last year. So, behind Apple and Google [Alphabet] and Amazon. But unlike those companies, Mercedes-Benz is generating a lot of cash and is paying an attractive dividend of over 7%. It's got a healthy balance sheet, about 40% of its market cap is held in cash, and its been able to fund the dividend, but also recently disclosed that it's going to be stepping up its buyback too, which will support the shareholder returns.

So, from a valuation perspective, its very attractive. And, meanwhile, were supportive of the company. It is facing a challenging backdrop currently and there is pressure from the market. However, we are supportive of this companys strategy, which has moved towards premium and luxury, [and that] should help the company to sort of navigate the challenging macro environment, because it will have superior pricing power and that brand is really going to come to the fore.

From a sustainability perspective, we see this as an improver. Theres a huge amount of change required in the automotive sector to move away from internal combustion engines towards electric vehicles. And a company like Mercedes-Benz, which is generating this cash, is able to invest in that technology and the software, the innovation, the data, to position its fleet for that change and be a leader. It's got some very ambitious targets to make that transition, and thats what we're going to be monitoring closely. 

Kyle Caldwell: As you mentioned, theres 36 stocks in the portfolio, and it's a concentrated approach. Could you give us a little bit more on why you've decided to go down that route in having a concentrated portfolio? 

Rebecca Maclean: Yes, it is a concentrated, highly active portfolio of 36 holdings. And were looking to be differentiated from the market and we're looking for different returns, and targeting attractive total shareholder returns. And one reason for this would be that there is empirical evidence which does suggest that it's the portfolio managers top ideas and highest conviction ideas which are more likely to outperform.

And so we’re concentrating our portfolio in the highest-conviction names that we have. But when were looking to add companies to the portfolio, we've got quite a high bar for what were looking for. Were looking for companies which are quality. So, theyre in attractive industries, theyve got strong competitive positions, theyve got attractive financial characteristics. Their ESG profile is strong, and [they have] sensible management teams. But were also looking for the income and that income growth and sustainability criteria, so its quite a high bar. We are trying to select the best companies and construct a diversified portfolio, but with our highest-conviction names. 

Kyle Caldwell: In terms of income growth for Dunedin Income Growth, the trust has increased its dividend since 2011. How sustainable is the dividend going forward? And in terms of the dividend reserves, how healthy are they?

Rebecca Maclean: The trust has either held or grown its dividend for the last 43 years, so thats an impressive track record. And its certainly a priority for the trust to continue to deliver resilient and growing income to investors.

One of the benefits of the trust structure is that we have these revenue reserves which allow us to smooth some of that volatility from an income perspective on an underlying basis.

For example, during Covid, the trust was able to grow its dividend, meanwhile, the underlying income generation from the portfolio was down 10%, which was better than the market because the market was down 30%. So that speaks to our approach in terms of trying to look for resilient income. But the trust structure certainly does help smooth that.

Weve currently got about two-thirds of an annual dividend in revenue reserves at the moment. Last year the dividend was at 99% covered by earnings. And we also have a strong capital position too. So, the company is in a healthy position. 

Kyle Caldwell: Rebecca, I appreciate your time. Thank you for coming in. 

Rebecca Maclean: Thank you for having me. 

Kyle Caldwell: Thats it for our latest Insider Interview. Please let us know what you think. You can comment, like and subscribe and hopefully Ill see you again next time. 

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