A guide to Schroder Income Growth Trust

The Schroder Income Growth trust aims to provide investors with a growing income (ahead of inflation) and capital growth as a result of the rising income. It invests mainly in the shares of UK larger and medium-sized companies, although it can also invest some of the portfolio in the shares of firms listed abroad.

Having managed the portfolio since 2011, Schroder head of UK equities Sue Noffke invests in UK companies of various sizes, with the combination creating a portfolio of high-yielding companies together with lower-yielding businesses with a greater focus on future growth. She is joined on the team by Matt Bennison, Tom Grady and James Goodman – and also has the support of the large team of UK-focused managers at Schroders.

The portfolio also has an unbroken 28-year record of annual distribution increases for shareholders (the trust is one of the AIC Dividend Heroes), with real term growth of dividends sitting at 1.9% per annum. Annualised dividend growth stood at 4.2% between 1996-2023, versus inflation at 2.3%*.

Core portfolio with a bottom-up approach

This is a core UK offering which invests in 35-55 stocks on a bottom-up basis, with no specific style bias. Up to 20% of the portfolio may be invested in the shares of companies listed on recognised stock exchanges outside the UK.

The investment process starts with idea generation, with investment ideas coming from a variety of sources, such as industry research and quantitative analysis.

The research stage focuses on factors that influence a company’s ability to create value for shareholders over the long term. The team meets with company management in advance of investing and meets most FTSE 350 companies each year to review the investment case of companies not held in the trust. Large and mid-sized companies form the majority of the portfolio.

In order to meet the trust’s income objectives and to provide diversified sources of income, the team looks at both yield today and growth in the future. This strategy results in the portfolio being split into three equal buckets for potential investment. These are: lower-yielding companies with faster growth; market-average yielding firms with better income growth; and high-yielding companies with lower growth.

Despite having a core position, this does not preclude the manager from making strong active positions – this includes the current climate which we discuss in the “Manager’s view” section below.

Why now for this portfolio

• Strong track record of delivering a growing income and capital growth.
• The team have made a strong move into UK mid and small-caps with a view that both segments are primed for a significant re-rating.
• At almost 14%, the team have taken advantage of the mis-priced opportunities in the market by using a significant amount of the gearing available to them* (investors should be aware that, as well as enhancing returns, gearing can also exacerbate losses in the portfolio).
• At 9.9%, the discount on the trust is significantly wider than the average (2.6%) over the past five years**.

Manager’s view

“We are pedal to the metal on this portfolio”

The team believe there is a significant opportunity in the UK mid and small-cap market at present and have positioned the portfolio relatively aggressively to take advantage. Figures dating back to 1955 show UK mid-caps have delivered an average real return of 7.8% annually***. That mix of global leaders and burgeoning businesses has meant they also typically outperformed the FTSE 100, producing an average annual return of 8.3% vs. 4.8% in the past 25 years****. But there has been a de-coupling in the past couple of years that has seen large-caps outperform mid-caps.

Matt Bennison says that when mid and small-caps have underperformed to this extent in recent history, it has normally been followed by a strong period of outperformance over the following three to five years.

He says: “The kicker for us is the de-rating of small and mid-caps which means the yields on both are a lot more attractive than they have been historically. We like to balance the capital growth and the income objectives of the trust, but the one thing that has constrained our ability to go into small and mid-caps has been that they have both tended to yield significantly less than the FTSE 100. That is no longer the case.”

This has subsequently changed; as of writing, the dividend yield on the FTSE 100 is 3.6%, while the FTSE 250 is slightly lower on 3.2%^. The team have already made their move; the trust now has 25.4% in small and mid-caps (this compares with 16% for the FTSE All Share)*. Gearing is at almost 14% on the portfolio having fully deployed the £30m facility for this*.

Bennison says: “We had a serious debate about gearing with the board, given the cost of funding has risen in the past two years – but we feel the opportunities are so strong in the UK that it feels like a time to be fully deployed. The market has risen quite nicely over the past 12 months (FTSE 100 and FTSE 250 are up 14 and 18% respectively). We feel as if there are signs of a nice recovery in the UK equity market which should continue. It is a reflection of the valuation opportunity.

“Our approach to portfolio management still remains very balanced and diversified, but as far as our tilt to small and mid-caps and the trust using gearing, we are quite punchily positioned for us.”

One of the opportunities within the UK mid-cap space is that the split between domestic and overseas revenues is 50/50 (large-caps are skewed to the international, while the FTSE Small-Cap is more domestically focused). Bennison says because they are more internationally exposed, larger businesses can find it easier to grow their addressable market. An example is defence technology company QinetiQ, which benefits from the AUKUS partnership between the UK, Australia and the US – with money going into defence budgets from those nations.

By contrast, they also have a raft of domestic names like Pets at Home and Hollywood Bowl. The latter has emerged from Covid stronger, having had a conservative position on their balance sheet.

Bennison says: “While many competitors struggled – Hollywood Bowl has added to its market share. It’s affordable leisure, cheap fun for all. Management has done well with little things like investing a bit more in their data offering to understand their customers better. This includes more tailored offers or a nudge if they’ve not seen a customer for 3-6 months. They now know little things like how many people are in a customer’s family.

“The strong balance sheet means they can pay a special dividend on top of their ordinary dividends as well.”

How has the portfolio changed?

Mid-caps to the fore

While the portfolio is not macro-focused, the team does a lot of work on the fundamentals to spot a mis-priced asset – attention then shifts to the investment thesis of each individual company. As companies reveal results or make announcements to the market – the trust’s managers will be content, provided the operation of the company remains in line with the investment thesis. They believe the market will eventually reflect the aforementioned mis-priced opportunity in those shares.

In the 12 months to the end of March 2024, the team has made six new additions to the portfolio, four of which sit in the FTSE 250*.

Cranswick plc, a food producer and supplier of premium, fresh and added-value food products, is an example of a company the team have been scouting for some time.

The firm primarily focuses on pork but has been moving into the poultry markets, and sells predominantly to major supermarket chains in the UK. Bennison says they have excellent service levels in an industry which is underinvested and has poor ethical standards.

He says they are disciplined capital allocators so when they expand into a new area – like they are currently doing with poultry – they are clear on the return on capital hurdles that they have set and make sure (as far as possible) they know the demand from customers. In addition, chicken is an area of the market where suppliers haven’t delivered what supermarkets require.

Bennison says: “Cranswick has upped its game and taken market share. Long-term returns from the business are phenomenal.  If you invested £10,000 in 1992 it would be worth over £2m now. That is from a bacon factory in Hull.

“The opportunity is there – you don’t have to be a jazzy tech company in the US to make a huge amount of money for shareholders. These types of businesses are fantastic at what they do – they are well managed and they are focused on shareholders. We knew about them for a long time and waited for a valuation opportunity – they also have a strong dividend history.”

Other examples include British Land, where the team felt the valuation discount to the true asset value became overly stretched in the final quarter of 2023. Bennison points to a dividend yield of 5-10% (which is well covered) and strong rental growth. The business is targeting London offices and out-of-town retail parks, with rental growth coming through in both areas.

XPS Pensions is a pension actuarial consultancy business. They advise corporates on anything pension-related (such as moving from a DB to a DC scheme). Tweaks to pension legislation normally happen when you have a change in government – this means corporates need an advisor, like XPS, to tackle this. Bennison says there have been further opportunities given the rise in interest rates. He says: “Lots of DB pension schemes are now going from being in deficit to a surplus. This means the trustees of those schemes are in a position to look for buy-ins and buyouts to take the liability away and hand it to an insurer. XPS handles the administration of this, with the firm being a cash-generative business with dividends on the rise.”

Other names added include Inchcape, a multinational distribution, retail and services company, as well as the FTSE 100 pair Diageo and Smith & Nephew.

By contrast there have been four sales, two of which (Spectris and SThree) were because the team felt both companies were fully valued. The others included Tesco – where the team believe the investment thesis played out following a strong recovery in the past decade.

PayPoint was also sold following a thesis drift. The firm did a large acquisition of Love2Shop. Bennison says the team were concerned about some of the risk associated with that move. Ultimately, they felt the business was moving away from the core offering they bought into.

Performance

Over the past three years, the trust has produced a positive NAV total return of 20.6%, marginally below the 21.8% produced by the AIC UK Equity Income sector; however there is a greater disparity between the share price total return when compared with the sector (9.5 vs. 18.9% for the sector)^^.

Over the past year, the trust has slightly outperformed the FTSE All-Share (14.8% vs. 15.9% NAV total return for the Schroder Income Growth portfolio)^^^. It should be noted the strategy does have a greater exposure to small and mid-caps than the FTSE All-Share – more domestically-exposed companies have suffered from the challenging macroeconomic climate. The trust has had some adverse performance within the consumer discretionary, industrials and basic materials sectors, offsetting positive performance in consumer staples.

What else do you need to know?

Buybacks, M&A and dividend hero status

While the trust has not had any recent merger & acquisition (M&A) activity, the team believe they have a number of businesses which are good candidates. However, the low valuations in UK equities have resulted in a number of company boards favouring share buybacks over special dividends.

Whilst some holdings posted notable increases in dividends in the portfolio, eight of the portfolio’s holdings kept their dividend level with prior years. Of these eight, seven rewarded shareholders through a share buyback programme, supporting the view they believe these companies are undervalued.

Bennison says: “UK companies returned about £100bn back to shareholders each year in the form of dividends (4% yield) but over the past two years they’ve returned about £50bn in buybacks. So they’ve topped that dividend yield up by 50%. This has given investors a 6% UK market yield^ – that buyback yield is a pure example of boards looking at their shares and thinking they are cheap and a good investment opportunity.”

It is worth noting the board of this trust have bought back some of their own shares for the first time since the Global Financial Crisis.

Outlook

This is what a core holding looks like when it is swinging the bat

Sue and the team are clearly backing their view that UK small and mid-cap equities (and to a degree large-caps as well) look so attractively valued that now is the time to take advantage. Having fully deployed their £30m gearing facility and increased their exposure to mid and small-caps to over 25% of the portfolio, the trust is ripe for a strong upturn, should we see signs of a re-rating in these segments.

It should be noted that the punchier position has to be put into context. Other trusts which are more deep value or growthier will inevitably have higher tracking error through the cycle, but this is a strong move given the way the team run money.

Importantly, attractive yields in the small and mid-cap markets (coupled with the increased share buybacks) mean investors are being paid well to wait. The trust has an excellent long-term track record since Sue took over and now may be a good time to consider the portfolio, as mis-pricing opportunities and a wider discount versus history make it an attractive entry point.

*Source: Schroder Income Growth presentation, June 2024

**Source: FE fundinfo, 15 July 2024

***Source: Martin Currie, Are UK mid-caps set to shine?

****Source: Schroders, Could UK mid-sized companies be about to reverse a topsy-turvy decade of underperformance?

^Source: Dividenddata.co.uk, July 2024

^^Source: AIC, 16 July 2024

^^^Source: FE Analytics, figures in pounds sterling, 14 July 2023 to 16 July 2024