Are global equity income funds a must-have in 2023?

Hello, I’m James Yardley, and today I’m joined by James Harries, the Elite Rated manager of the Troy Trojan Global Income fund. James. Thank you very much for joining us.

[00:11] Hi. Thanks very much.

James, maybe we could start, if you just want to give a little bit of an introduction to the fund. What is its objective and what sort of companies do you invest in?

[00:23] Certainly. So, it’s a global equity income fund. We’re trying to produce a balance between capital growth and income growth. We think that both of those things matter for investors, particularly if we’re moving into a more difficult period, We’re trying to produce above average returns relative to our peers, but with below average volatility. And we think both of those things matter. For this fund particularly, and often for Troy more broadly, we think that our key investors are those who have irreplaceable capital, if you like, and are in need of income. And those two things often coincide in retirement, and we’re very cognisant of that. 

Now, of course, when you are young, volatility is your friend. You’ve got plenty of time to make up losses if you suffer a steep drawdown or a steep loss. But when you are not so young, that isn’t the case, and actually, volatility is your enemy. And we at Troy very much try to limit significant losses in order to consistently compound capital, and we think that makes for a better long-term return stream, particularly for the type of investors that I mentioned. So, that’s what we’re trying to do. 

Now, the companies we try and invest in are those that we think are high quality, that are resilient, that are adaptable, but that have sustainably high returns on capital employed, and they tend to reside in particular sectors. So, the majority of the fund is invested in areas like consumer staples, in healthcare, in particularly enterprise, as opposed to consumer technology companies. And these are businesses that we can have something that we can say something sensible about what they might do on a 5, 7, 10 year view. We have very low turnover in our portfolios, and our holding periods are 10 plus years. 

So, we want to be pretty certain about the types of businesses in which we invest and the resiliency of the cash flows, which they produce. So, that’s where we concentrate our investments.

And I think you’ve said recently you expect global equity returns to be lower going forward. So, why is this? And also maybe connected with that, I mean, do you think we’re going to now see a period where investors kind of look more favourably on dividend investing again? Whereas of course, the past few years until recently, it was all about the high-flying tech companies?

[02:38] Well, absolutely. I mean, we’ve been investing on this basis for a long time. And we know that income investing tends to come into and go out of favour, depending on what recent returns have been. 

Of course, when the market’s delivering you very strong returns, the riches that you are benefiting from completely outweigh the incremental but relatively dependable return you get from an income stream. 

Now, my contention is that we have a slightly unfortunate, you might say, or a slightly different backdrop today, to that which we’ve been in for the last 10, 12, 14 years. Of course, for all that period, money has been essentially free. We’ve had very, very low interest rates, and we’ve had incredibly supportive policy, both monetarily, but also more recently fiscally, because there was no inflation problem. And so, the authorities could be very, very supportive and really quite aggressive in the way they supported equity markets, with the intention to push up asset prices to stimulate consumption, to help the economy.

Now, of course, that was all fine until inflation appeared, and it has. And so that means two things. Number one, valuations were driven up to a level which is actually pretty elevated relative to history. And number two, that policy is likely to be less supportive in the future than it has been in the last 12, 14 years. After all, interest rates have gone up really quite substantially over the last few months. 

Now, the reason we think therefore that returns are likely to be relatively low, is because returns are a function of initial valuation. If you buy an asset relatively inexpensively, then you can expect reasonable expected returns in the future. But the opposite is also true. If you have elevated valuations, that implies low returns. 

Now, if we are in a period where returns are like to be lower, assuming that markets don’t fall substantially or therefore are re-priced substantially, and therefore the expected return improves. But if that isn’t the case, then the returns are likely to continue to be relatively low. Now, in that case, as I mentioned, the dependability of an income stream and the incremental return that is generated by that income stream, in the context of relatively low overall total return, can be very powerful and can be very useful, particularly as I mentioned, for the type of investors that we target, who have irreplaceable capital and are in need of income. So, put all that together, we think that yes, income investing is likely to be a little more favourably looked upon by investors in the next few years, than it has been potentially in the last few years.

And you mentioned that dividend policies tell you a lot about a company. What do you mean by this?

[05:11] Well, a dividend policy is, I mean, obviously a dividend is a reward in a sense for being a shareholder, but it also is a number of other things. A dividend is in a sense, a management team’s or more specifically, or more properly perhaps, a board’s best guess at what a sustainable mid-cycle through the cycle earnings number is, for a company. You shouldn’t be distributing more than a proportion of that, that you think is bearable by the company. 

But it also tells you what the capital intensity of that business is. If you’re able to pay out a reasonable level of income, paid out of so-called free cash flow, or cash flow is generated to buy the business after all the other capital needs of the business have been met, then it tells you something about the type of businesses you’ve got. And really high quality businesses that have low capital intensity, tend to be able to play high and sustainable dividends over time.

It is also a constraining influence on management teams. So, if you pay too much of a dividend, it can mean that you underinvest in your business. But if you don’t pay any dividend at all, you can end up squandering capital. So, the level of dividend also is a constraining influence on management teams and tells you something about how they think about allocating capital in the portfolio, both with regard to shareholders, but also the business itself. 

And then the final point is that, what a management team does with the dividend – sustainably grows it through time or a step change in both the growth or not – tells you something about the success or otherwise – or the confidence or otherwise – of the management team and the board of the business. 

And a very good example if we’ve had of this recently, is Reckitt Benckiser [Group plc], which is a business that would be familiar to many people. It makes health and hygiene products, effectively. Some of the portfolio makes you feel better if you’ve got a cold or flu; some of you it helps you clean your house. They have an infant nutrition business as well. But more recently, the management team have put the dividend up by 5% after a long period when that hasn’t been the case. Now, our contention is – our view is – that Reckitt Benckiser, after a long period of having a number of one-off problems that they’ve had to deal with, is now moving into a phase where that business is really finding its feet. 

And we’re expecting that that business will now be able to continue to compound consistently over the next few years, over the next few years, in the way that it did, before it had this period of some difficulty. And we think by putting up the dividend by 5%, the management team are indicating greater confidence in that business. So, a dividend has lots of information within it, about the level of, its growth over a number of years, how it relates to the capital intensity of the business, but also how the management team and the board are thinking about the business over the next few years, and the confidence they have in that business.

Very interesting. Yes, I think we’ve all used Reckitt Benckiser’s products, I’m sure <laugh>. And yeah, so maybe if you want to tell us about a few other stocks in the portfolio: what else is exciting you at the moment?

[08:09] Well, a couple I might highlight, I suppose. One would be a company like Pepsi [PepsiCo, Inc.]. I mean, Pepsi is an absolutely classic, global, high-quality, consumer franchise, which we think will be able to pay and grow dividends, long into the future. 

Now, Pepsi’s an interesting business because, you know, it’s called Pepsi, but actually, it’s really a snacking business. Although Pepsi is obviously a brand that’s very familiar to people, the really key, the jewel in the crown of this business, if you like, is the US snacking business – by that I mean effectively, salty snacks, crisps, and so on. 

And effectively, it has some really dominant brands in this sector: it is 10 times the size of its nearest competitors; it has enormous power and force with retailers and enormous familiarity with consumers; and, of course, and it has an international business which has a very long runway for growth. 

Now, what’s interesting about the snacking business, of course, is it’s one of these areas where, when you want to buy a packet of crisps, you know, you feel like a little treat and you tend to do that periodically, and you don’t care too much – too much – about what the cost of that little treat is. And that enables Pepsi both to have attractive margins, but also to be able to increase price, should there be a more inflationary backdrop, which they have very ably demonstrated recently. So, it’s a wonderful franchise, it’s a wonderful business. It’s the sort of business we can hold forever and will deliver us a return pretty consistently balanced between income and growth. 

The second one I would mention is a slightly different business. It’s Nintendo. Again, it’s a business that will be familiar to many of us, but particularly our children. My son is a very keen Nintendo gamer as I have to say I was when I was a child, and actually that’s quite interesting. [JY: That’s definitely familiar to my son, that’s for sure <laugh>. ] Well, there you are! But that’s quite interesting itself because it’s a family-friendly, gaming company. It has basically timeless IP [Intellectual Property]. I mean, I was playing Donkey Kong in the same way that my son plays Donkey Kong, all these years later. And that shows you the sort of strength of the intellectual property which Nintendo has, and which we view as being under-monetised, if you like, relative to other globally recognised, incredibly powerful intellectual property. 

Now, the reason we’re particularly excited about Nintendo’s prospects today is first of all, it’s relatively inexpensive. It’s completely ungeared, has net cash on the balance sheet. But others may have known that they’ve recently launched a film, Super Mario Brothers, which I have to say I went to see at the weekend, and I thought was very, very good, as did my son. And, to be more serious for a second, and also absolutely smashed all box office records. It’s the most successful opening weekend for any animated film, beating Frozen II. I mean, it’s absolutely incredible. Funnily enough, the critics didn’t particularly like it, but all the consumers love it, which probably tells you something about the critics! 

Anyway, what’s interesting about this, to be serious for a second, is not simply because it’s a great success, the film, but it demonstrates that Nintendo is serious about monetising in a greater way, this incredible, timeless portfolio of IP that it has. 

The second point to make is that it’s currently got a console called the Switch, which is one of the most successful consoles of all time. But in the past when Nintendo has launched a new console – and the Switch is relatively long in the tooth – some of them haven’t been a great success. Now our view is, because you now have an individual account with Nintendo, through which you download software and upgrade the operating system, the persistency of the client base from the Switch to the new console, which is going to be called the Switch Pro and is likely to be launched this year or next year, is going to be far more predictable than in the past. And if that is the case, then we think the share price will react very positively to that. 

So, it’s a well-known global, again, franchise gaming company, which not only do we think is a wonderful business, but we think is particularly well positioned today.

Well, that’s absolutely fascinating, thank you very much, James, those were some really good examples.

[12:15] Thanks very much indeed.

And if you’d like to learn more about the Troy Trojan Global Income fund, please visit FundCalibre.com