17 September 2020 (pre-recorded 16 September 2020)
Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.
[INTRODUCTION]
Chris Salih (CS): Hello and welcome to the Investing on the go podcast, I’m Chris Salih and today we’re joined by Kevin Murphy, co-manager on the Elite Rated Schroder Income fund. Thank you for joining us today Kevin.
Kevin Murphy (KM): Morning Chris, thank you for your time.
[INTERVIEW]
[0:15]
CS: There’s only one place to start I’d assume and that’s with dividends. Since the fund was launched, you’ve sort of averaged around 5% annualised dividend growth. Where do you see dividend growth going forwards?
KM: Yeah, so in most years, dividends for the market grow, but there are obviously occasional years when they are cut and this year, as you well know, is one of the disappointing ones when they were cut, there’s no getting away from that. And the cuts have been significant and widespread and will impact every portfolio manager in the UK, and every saver who’s reliant on that income, and it is an extremely difficult time.
The good news is the market levels have adjusted to take into consideration what has happened to dividends. And the question is what’s going to happen from here? And from a purely mathematical perspective, the highest growth you get from dividends is following a dividend cut. So, since 1988, when the fund was launched, as you correctly say, the income’s grown significantly and it’s tripled over that timeframe. But the fastest growth that it has ever seen was following the market cuts of 2008, 2009, when the portfolio’s income grew at 10% per year for a decade. And that level of income growth is extraordinarily attractive. Given the scale of the dividend cuts this time and the multiple avenues for those dividends to grow, it is not inconceivable that we see that level of income growth over the next 10 years.
[1:35]
CS: Given what you said there then, how do you look to manage income funds effectively in this climate? Is it a case of sort of holding your nerve, maybe give us an example of what you’re sort of doing in this environment.
KM: Yeah, it isn’t easy. And I think you need to be clear on what your fund is trying to do. So our strategy, our aim, is to provide an attractive and growing income stream over time. Our fund launched in ’88 and since then, at that point it had a yield of 3.5%, and the fund still yields 3.5% today, but over that 22 year period, the income has tripled. So we always say, you should focus on the income, not the yield, because it’s the income that over time will grow. And it’s the income that will drive the capital. Today, the yield of the fund is just shy of 4%. And when we’re looking at new opportunities, we want them to be additive to the portfolio’s income, but also to provide an opportunity for that income to grow over time. And that’s the focus, to find an attractive income stream today, but also for that income to grow over time, which should drive the capital growth of the portfolio as a whole.
[2:43]
CS: Could you maybe tell us what companies have been saying to you about the cuts? I mean, is it their intention to reinstate dividends soon? Will they do it at low levels? What sort of messages are you getting from them, from the companies you hold?
KM: So, by and large companies want to pay dividends. Just this week I was told by FTSE 100 CEO that they felt it was their moral imperative to pay a dividend. As many people genuinely live off the dividend income. But for some companies at the minute it’s not currently prudent to do so and pausing their dividend is absolutely the right thing for some companies. For others, whilst they could currently afford to pay, the level of uncertainty means they’re reluctant to reduce their cash buffers by paying a dividend, just in case the economy takes a step back when furlough ends or there’s a second wave, et cetera. But irrespective of the rationale for pausing the dividend, dividends will come back and they’ll be reinstated gradually.
Some dividends are unlikely to get back to the highs that they were beforehand because the companies were over-distributing. They were spending too much of their own money on dividends – the oil companies or some life insurance companies make it into that category. But from today’s level, you don’t need to assume you get back to historic levels as an attractive yield today. And those and many companies should be able to sustain and grow their dividends over the foreseeable future.
[3:58]
CS: Well, just to follow up, you touched a little bit on it there. We’ve heard about this idea of a bit of an income reset for some companies. I mean, are you seeing some of them do other things with their profits and maybe tell us if they are, what they’re doing, et cetera?
KM: So not yet is the answer. So as companies have paused and chosen to pause their dividend, the only thing they’re doing is to save the money. So they’re taking the cash and they’re building balance sheet strength. They may be paying down debt, but they’re not for example, doing what you may see with traditionally with the cut dividends such as making acquisitions or buying back shares. You’re not seeing that, it is just purely for balance sheet prudence and to conservatism that some of those dividends are being cut.
[4:40]
CS: Okay. Yourself and Nick Kirrage have managed the fund for more than a decade, in that time have you always sort of allocated a proportion of the fund to non UK listed equities and maybe tell us why and what sort of companies you’re finding exciting in that space today?
KM: Okay. So under the fund’s rules, and it’s the same rules that most income funds operate under, we’re allowed to have up to 20% in non UK equity holdings. And the UK is very well represented – as in the UK is a sophisticated, mature financial market and it has most sectors. And the UK has plenty of opportunities in, for example, the mining sectors or the banking sectors, but it does have a dearth in some other areas.
So, we tend to use our overseas allocation to get access to stocks which we can’t get within the UK, or where we think there’s some very high quality companies, with solid balance sheets and attractive valuations. So, examples of those companies today would be pharmaceutical stocks, such as Pfizer and Sanofi, Pfizer quoted in the US, Sanofi in Europe. Some of the US tech names such as Heward Packard and Intel or the Italian oil company, ENI. All of these companies are ones where, whilst the UK may have a name or two in that space, we think that space justifies an increased weighting and increased exposure. And we’re unwilling to concentrate into the UK names. So that overseas safety valve just gives you a little bit extra diversification. And you, if you can do that whilst not taking an excess balance sheet risk, without taking undue currency risk and without taking a valuation risk, then that’s an extremely attractive opportunity for us.
[6:15]
CS: You mentioned that sort of overseas safety valve. I mean, obviously the environment’s different today to what it was five years ago and certainly 10 years ago. Has the themes, or has the sort of stocks you’ve been picking been in the same sort of areas over that time? Has it changed with, say Brexit, for example, maybe just give us a bit of an idea of that please?
KM: Yeah. So Brexit hasn’t changed it, but over the course of the last 10 years, of course, the opportunity set has changed. So, if you went back and looked at the portfolio 10 years ago, there would have been exposure to German post office, for example, there may have been exposure to some US universities, what’s called the for profit education sector, there would be a greater weighting in the technology space where we had at that point, Microsoft, Intel, Heward Packard, you know, we had a large exposure to US technology shares, but as those shares have done well, we’ve rotated out of those and sought new opportunities. So ,the pharmaceutical stocks, for example, are newer opportunities, ENI the oil company is a post-covid purchase for the portfolio, taking advantage of some of the dislocations that that area has seen in the market place. So that is over time, you should expect those exposures to adjust and to reflect the opportunity set on a global basis. But because it is a safety valve away from the UK, we don’t, you’re unlikely to see us invest in overseas banks or overseas mining companies, because simply the UK has enough as it is.
[7:48]
CS: I just wanted to conclude by talking about a couple of the stocks in the portfolio. You’ve recently bought Carnival, the cruise ship operator, and also M&S while, by contrast ,you sold some of your holdings in some of the other supermarkets, could you maybe just talk to us about a couple of those please, well your choices please if possible?
KM: Sure. So covid is providing a challenge to many businesses and business models, and it’s our job to kind of look through the short term dislocation and try and use the lower share prices to purchase companies that we think are sound in the long term. So Carnival is the worldwide cruise company for those who don’t know. And it’s an example of a company, which is clearly going through very difficult period, the balance sheet is stretched and it doesn’t pay a dividend. So we couldn’t justify a position within the income fund for the equity, for the shares. However, the debt of the company is attractive.
So companies can borrow money from financial markets and that is known as debt. And when you purchase that debt, you effectively gain access to the dividends, the coupons that that debt is going to pay. And Carnival issued that debt in the teeth of the financial crisis, in the teeth of the covid crisis, and the debt has a very attractive income of greater than 10% a year with significant protections against the event of a default. So the ships, they borrowed against the collateral of their ships and the ships would have to decline by 80% before we would take a haircut to our loan to the company. And as such, we felt that was, with a 10% return per year, and with very great protections on the downside, that was an attractive risk/reward trade. We have owned debt instruments in the past, in the last financial crisis, 2008, 2009, we bought significant numbers, but I haven’t found many opportunities of late until the Carnival bond and Carnival is basically the only one that we have in the portfolio today.
Turning to M&S, M&S is effectively two businesses. It’s a significant food business, with a more challenged home and clothing business alongside. The food business is performing well, whether it be the food halls within the largest shops, standalone food halls, stalls, or its recent partnership with Ocado in the UK. The clothing and home business has significant scale, reach, market share, huge numbers of shoppers through the door, but clearly it’s performing much, much worse, but that is the opportunity. The people through the door, if they simply bought one extra item, if they went into M&S, that it could transform the business. You don’t need to believe that today – buying the shares, the opportunity, the entire valuation, it could be justified through the partnership with Ocado alone. So you get the rest of the food businesses and the clothing and home business for free. And that’s the kind of opportunity we like. It’s balance sheet is reasonable. It wants to pay a dividend. But doing so in the current environment, clearly would not be prudent, but in time, these companies at M&S would drive the income and capital growth in the portfolio. And that is an example of having that focus on not just today’s yield, but that income growth over time that will drive the portfolio’s growth.
To fund those purchases, obviously we don’t have an unlimited amount of capital so when you’re buying things, you have to sell things on the other side. And so we’ve recycled money out of areas that have performed well and the food retailers are an example of a company or a sector, which have operationally performed very well through the downturn, have shrugged off the challenge of the discounters, they’ve operationally focused on their core businesses, and their performance through lockdown has been exemplary, as such positions increased in size because the share prices went up. And so we’ve trimmed them back a bit, but they remain large holdings within the portfolio, but we just used some of those profits effectively to fund additions into the Carnival, into the M&S.
CS: That’s great Kevin, thanks very much for joining us today.
KM: Not at all, thanks for the chance.
CS: And if you’d like to learn more about the Schroder Income fund please visit fundcalibre.com and while you’re there remember to subscribe to the Investing on the go podcast.
