The cheap stock market route to a better income

Take your pick from a dozen bargain-basement trusts.

Yield-hungry investors have a chance to pick up a raft of attractive income funds at bargain-basement prices, thanks to the combined effects of Brexit and the US election outcome. Stifel, the stockbroker, has highlighted more than a dozen investment trusts that are paying annual dividends of about 4 per cent — the target figure many income investors seek — but that are priced as much as 10 per cent below their true value.

Iain Scouller, of Stifel, says: “Income investment trusts have fallen out of favour in the past few months and many are cheaper than they have been at any time in the past five years. This represents a terrific opportunity.”

How the opportunity has arisen
Investment trusts are companies that invest in a portfolio of other companies. They are traded on the stock market and their price is determined by supply and demand. This means they can trade at a price that is higher (a premium) or lower (a discount) than the underlying value of the portfolio — the net asset value (NAV). This premium or discount will vary according to market sentiment and bargain-hunters tend to wait until a particular trust is at its largest recent discount to NAV before buying.

Stifel tracks these premiums and discounts every week and says the discounts on income trusts are at their biggest since 2011 because the sector has fallen out of favour. In some cases the discounts are as large as 11 per cent, which means that you are buying £100 worth of stocks for only £89.

What has pushed prices down?
Experts reckon investors have generally become wary and done some profit-taking after the FTSE 100 index of leading shares hit an all-time high in October. Income funds may also have undergone some selling because they don’t have a lot in commodity or energy stocks and have underperformed the mining and oil-rich FTSE index this year, after beating it in 2014 and 2015.

Another reason, says Mr Scouller, may be nervousness about the impact of a rise in interest rates, which might make the yields on income stocks look less attractive. However, he thinks that the yields on income stocks and funds may remain competitive.

The attractions of equity income trusts
Mark Dampier, the research director at Hargreaves Lansdown, the wealth manager, says: “Income trusts look like a real bargain right now. They typically trade at premiums to NAV, but many are on discounts of up to 11 per cent. That is rare and won’t last forever.”

He argues that the yields of 3 to 5 per cent on equity income trusts are so much greater than the 1 per cent payable on most deposit accounts that the case for income funds appears overwhelming for all but the most cautious saver. At the same time infrastructure funds, another potential rival to income funds, stand at 20 per cent premiums to NAV, and look very expensive compared with the 10 per cent discount on a number of income funds.

“Interest rates are going to stay lower for a very long time, so where will people go for their retirement income if not to dividends?” says Mr Dampier.

Charles Cade, of Numis Securities, the stockbroker, says sterling’s post-Brexit drop of about 16 per cent against the dollar and euro has given a large boost to these funds’ dividend payouts because about 70 per cent of the earnings of FTSE 100 companies comes from overseas.

Another plus point is that investment trusts are allowed to hold back up to 15 per cent of earnings a year to help to sustain dividend payments in lean years. Mr Cade says that some trusts have built up substantial reserves, including JPMorgan Claverhouse, which has 1.2 times its annual dividend stashed away, and Edinburgh and Dunedin Income Growth, which have reserves of 0.8 times their dividend.

This enables trusts to smooth their dividend payouts over the long term and some have very long track records of unbroken dividend growth. City of London leads the way with 50 consecutive years of dividend growth, followed by Bankers and Alliance Trust on 49.

The bargain-basement funds
Stifel highlights JPMorgan Claverhouse, yielding 3.7 per cent, which is on an 11 per cent discount, having traded between a discount of 11 per cent and zero over the past year. Other trusts include Merchants, yielding 5.7 per cent on a 9 per cent discount, Murray Income (yield 4.5 per cent, discount 10 per cent), Perpetual Income & Growth (yield 3.5 per cent, discount 8 per cent) and Standard Life Equity Income (yield 4 per cent, discount 9 per cent).

Mr Scouller particularly likes Merchants, Perpetual Income & Growth and Standard Life Equity Income. He says: “Merchants is a solid trust with an attractive yield that focuses on FTSE 100 companies and has a manager, Simon Gergel, with 27 years’ experience in the industry. The Perpetual trust also has a very experienced manager in Mark Barnett, though he has a lot more in mid and small-cap stocks and 12 per cent in international stocks. The Standard Life trust, run by Thomas Moore, is even more heavily weighted towards mid and small-cap stocks, but has no international exposure.”

Mr Cade selects Temple Bar investment trust, on a 10.1 per cent discount with a yield of 3.6 per cent. He says: “Alastair Mundy, the manager, adopts a more contrarian approach, holding a number of large caps which are generally out of favour, such as oil stocks. He has a very good long-term record.”

Mr Cade goes for Law Debenture and Acorn Income. He says: “Law Debenture is a global investment trust on a big discount of 12 per cent and a modest yield of 3.3 per cent. It is run by James Henderson, a very experienced manager, and it has a trustee business that generates 40 per cent of the income. Acorn Income yields 4.4 per cent and stands on a discount of 9 per cent. It is a combined equity and bond fund, with Fraser Mackersie and Simon Moon running a quality smaller company fund and Paul Smith looking after the bond side to enhance the yield.”

Alternative cheap deals
Kieran Drake, of Winterflood Securities, picks Henderson Smaller Companies. He says: “It has a strong performance record yet stands on a sizeable discount of 16.2 per cent. The fund has increased its dividend more than seven-fold over the past ten years and its 2.5 per cent yield is one of the highest in its peer group, which we believe is attractive when combined with the potential for capital growth.”

Iain Scouller goes for Murray International, a global income fund. He says: “It yields 4.2 per cent and stands at a 3 per cent discount. Bruce Stout is a very experienced manager and the trust has an excellent long-term track record.”