Top three income shares and avoiding dividend value traps

George Cooke, fund manager of the Montanaro European Income fund, a member of interactive investor’s ACE 40 rated list of ethical investments, targets companies with attractive dividend yields. He talks through his dividend checklist, and names the top three highest-yielding shares he is backing. 

Kyle Caldwell, collectives editor at interactive investor: Hello. Today I’m speaking to George Cooke, fund manager of the Montanaro European Income Fund. The fund invest mainly in mid-caps and small-caps that are listed in Europe, with one of the key focuses looking for businesses with sustainable, competitive advantages. So George, what sort of qualities do you look for to find those sorts of businesses that have a competitive edge over rivals?  

George Cooke, fund manager,  Montanaro European Income Fund:  Yes. So there have been entire textbooks written on the topic of competitive advantage, so forgive the brevity of my response here. But I think at its core what we’re looking for are profitable companies that are operating in niche but growing markets and are either the sole provider of a product or service, or are market leaders and taking market share.

From a financial perspective, some of the clues of competitive advantage can be things such as high returns on capital employed, strong balance sheets, good cash flows. It’s hard to have all those things I’ve mentioned so far without some form of competitive advantage.

I think what really matters as well though is the durability of that competitive advantage. To do that we have a large analyst team and they have a checklist, which is completed for every company that we look at, which has 34 separate criteria on it and that is really looking at what are the competitive advantages of a company today. What’s going to stop the competition from whittling them away? So that could be things such as patents, it could be contractual revenues or even just very efficient operations. And then we look at is the company investing to widen its moat and to ultimately get better, not just stay still?

I think while all of that is relatively scientific and can be quantified, the last thing I’ve got to say, and the thing that definitely can’t be measured, is management and culture. So we place a lot of importance on this. We meet the companies that we invest in, we meet their management, we go and visit them, at least when we’re allowed to get on to a plane. And that’s because we find that those intangible factors can often be the thing that really differentiates a truly great business from the merely good.

Kyle Caldwell: Environmental, social and governance (ESG) factors are fully integrated into the investment process. Could you run through how they are integrated?

George Cooke: Environmental and social and governance aspects, as you say, is integrated across all our funds and into our process. And it’s the analysts, the investment analysts, that conduct our ESG analysis because we think it is a fundamental part of the quality of a business. If a company has lots of negative externalities and they are not trying to reduce them or eliminate them, then in our view, it’s very likely that in the long term, they will come back to bite the company and impact the investment case negatively.

So we have three parts to our approach to this really. The first is simple exclusions. So we just do not want to allocate capital to certain parts of the economy. That would include oil and gas exploration or production companies, high interest rate lenders, pornography, tobacco, alcohol, weapons and gambling.

If a company is not doing those things, then we can move to step two. That’s where we do our ESG due diligence and once again we have checklists for this. So on the environmental side, we’ll be looking at things such as the carbon and waste water emissions, using both the company’s own data and also external providers.

On the social aspects, we’ll be looking at areas related to the UN Global Compact, so that could be bribery and corruption, treatment of the workforce, and so on. And then from the governance perspective it’s really the typical things you would expect. It’s things like board diversity, board structure and management incentivisation. Is the incentivisation set-up in such a way that management are incentivised to do the right thing and to allocate the capital properly?

The third part of it is monitoring and engagement. So we don’t just do the work and then forget about it and leave it forever. We’re constantly talking to the companies, we’re engaging with them. We want to see them constantly improving themselves as well.

Kyle Caldwell: I now wanted to move on to the income side of the investment process. The fund focuses on companies that have an attractive dividend yield, so how high is an attractive dividend yield and how do you avoid potential value traps?

George Cooke: Yes. Well actually we view high dividend yields as a warning sign more often than not. If you have a dividend yield of 10% or 15%, it’s usually just the market telling you that you’re about to get a dividend cut rather than this is a stunningly great opportunity.

So the objectives of the fund are not only to have a dividend yield which is higher than that of the MSCI Europe Ex-UK Small Cap Index, but also to deliver strong total returns and a growing dividend. We like to see the distributions growing by 5% per year.

When it comes to our process and how do we avoid value traps, our process can be split into two parts. The first part is building an approved list of the highest-quality growing companies we can find. So we don’t start by looking for a high yield. We don’t start by looking for very low PDs or anything like that. We go and screen our universe and look around for high-quality, growing companies.

When we think we’ve found one, it has to get through our investment committee and again they are voting at this stage as to whether it is a high-quality growing company. If the investment committee believes it is, than it can go on to our approved list. And it’s from that list that we pick the investments that can go into the portfolio. And so it’s after a company has gone on to the approved list that we worry about valuation and we worry about dividend yield.

So we do care about the yield. We do care about valuation but first and foremost the companies have to be high-quality and growing. And we think doing it that way round prevents us and helps to stop us from being seduced by an optically high dividend yield, which then turns out to be high for a reason, which is that the company is declining.

Kyle Caldwell: And what is the overall backdrop for European mid-cap and small-cap companies? Have the majority now returned to the dividend register following the Covid-19 pandemic? And could you name a couple of examples of companies you own that continue to increase their dividends during the pandemic?

George Cooke: Yes. I would say the dividend backdrop is slightly variable and that is really a reflection of the Covid pandemic itself. While it was clearly a very negative event for humanity, from a company financial perspective, the effects of the pandemic and the government responses to it have been very variable and have led to quite clear winners and losers.

The majority of companies, have now in 2021, reinstated their dividends but we have a real mix within that. So as you sort of referenced, we’ve got quite a few companies who grew their dividends throughout the pandemic. So to give you a couple of examples there, we’ve got Avanza (OMX:AZA), they’re the market-leading savings and investment platform in Sweden. Thermidor are a wholesaler of plumbing supplies and Medistim, a medical device company, and they focus on intra-operative quality control products that are used in cardiac and vascular surgery.

Now it’s not to say that those companies weren’t touched by the pandemic, and particularly in the second quarter of 2020, they did feel some impact. But they quickly rebounded and saw their businesses growing and so they were able to grow their dividend, both in 2020 and we think going forwards.

Kyle Caldwell:  You mentioned earlier the dangers of being seduced by a high dividend yield. I was hoping that you could run through the three highest-yielding shares in the fund, which I presume you believe are sustainable going forward.

George Cooke: It’s a very cruel question to ask of an income manager because the high yield can often mean high risk, but I will talk you through them. So the highest-yielding company in the portfolio is a company called Kid. That has a trading dividend yield of around about 8%. Now they make interior furnishings and products for the home, so a particular focus on soft furnishings too, so things like curtains and duvet covers and so on and so forth.

They’ve got operations in Norway, where they sell via their Kid interior brand, but also in Sweden, Finland and Estonia where they sell via their Hemtex brand. They’ve got an omni-channel approach, that’s a fancy way of saying they’ve got both bricks and mortar stores and an online presence. And their growth is going to come both from rolling out more stores, there’s more room to do that, but also really expanding that online presence, which is going from strength to strength.

Now, as you say, a yield that high can be a warning sign but in this case actually all the numbers are moving in the right direction. And so we think that yield is more of a reflection of the fact that this is a sub €500 million market cap company, so it probably hasn’t got on to the radars of some of the larger institutional investors. And so if we’re right about that, and if the company continues to execute as it has been doing, than hopefully that will prove to be a good investment driver as it gets bigger too.

The second highest yielder is a company called Fjordkraft, also a Norwegian business by chance, and they have a trading dividend yield of around about 7% and they’re an electricity retailer, so they sit between the producers of electricity on the one side and customers on the other. They are the market leader in Norway, and this is a scale business. If you’re the biggest player you can spend the most money on marketing and branding and, of course, technology, which helps to make your operations more efficient on the backend.

There’s a little bit of growth here because they’re expanding into some of the neighbouring countries and they’re providing some ancillary services to their existing customer base. One thing that we do have to accept though is that this business has some exposure, a small but some exposure, to energy price fluctuations and so that can affect the short-term numbers.

If we look back in 2020 they had a phenomenal year, energy prices were very, very low and the company made extraordinary profits. In 2021, it’s the polar opposite, they’ve had a very tough year because energy prices have been abnormally high and so that has hit them without coming close to making them loss-making or anything like that.

So we think that actually it’s that short-term fluctuation, which as long-term investors we’re happy to look through and we think that underneath all of that there is a high-quality and growing business here, but it’s that short-term headwind that they’ve been facing that presents such a good value opportunity and means the company has got the yield that it has.

And the third example is Red Electrica (XMAD:REE), they’ve had a 6% or so trailing dividend yield, and they operate the Spanish electricity system. As you can probably imagine, this is the natural monopoly and so it’s very heavily regulated. With that regulation though comes really very high stability and visibility over a decade and more, so that’s always a nice thing to have when you’re an income investor.

There’s an ongoing need for investment here, too, as they make new interconnections with some of the neighbouring countries. And so that’s where we’re going to get a bit of that long-term growth from, in our view.

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

George Cooke: Thank you.

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