Murray Income Trust — Attractive income and long-term outperformance

MUT’s manager Charles Luke believes that the level of uncertainty about the global economic outlook has increased significantly since Russia’s invasion of Ukraine, which has robbed the post-pandemic recovery of momentum, due in large part to its impact on energy and food prices. These factors are compounding inflationary pressures that existed before the outbreak of war. Inflation reached multi-decade highs in late 2021 in the United States and other major economies due to widespread commodity price increases and supply constraints for key manufacturing components, especially the semiconductors essential to the production of electric vehicles and myriad consumer goods. Ongoing factory closures in China are adding to these shortages.

These inflation pressures have fuelled investors’ fears of higher interest rates, and these fears are starting to be realised. The Bank of England initiated a series of base rate rises in December 2021, while the US Federal Reserve took its first tightening step in March and has signalled that further moves are imminent.

Rising interest rates have triggered a sharp style rotation in global equity markets in the past few months. This rotation has favoured lower-quality cyclical and value stocks at the expense of quality and growth companies, which tend to have a longer duration of earnings. As Luke observes, ‘concept’ stocks – mostly technology companies with little or no current cash flows – have been especially hard hit by this sell-off because higher interest rates affect the value of future cash flows, and hence stock valuations.

Despite the worrying global backdrop and recent market volatility, Luke views the UK equity market environment as ‘generally supportive’, for several reasons. The UK’s vaccine booster roll-out has been rapid, and he sees persistent pent-up demand, especially for travel, experiences and entertainment, following the succession of lockdowns over the past two years. While the manager acknowledges that cost of living increases, especially the prospect of further rises in utility bills, are weighing on disposable income, he notes that the UK’s medium-term inflation expectations remain stable.

Luke also sees good value in the UK equity market, which he maintains has been ‘very cheap’ since Brexit, with UK stocks in many sectors trading at a discount to their US peers. For example, the UK market’s 12-month forward P/E is currently 11.4x, compared to 15.1x for the world market (according to Datastream). Furthermore, its dividend yield (currently 3.6% as calculated by Datastream) remains at an ‘appealing premium to world equity markets (which have a dividend yield of 2.2%), let alone other asset classes’, he says.

In the manager’s view, the UK market’s relative attractiveness means many stocks are potential takeover targets for private equity investors and competitors seeking greater market shares. This includes foreign investors, who remain underweight the UK market. Indeed, UK merger and acquisition (M&A) transactions reached a record £175bn in 2021 and MUT’s portfolio companies Sanne, an asset administrator, and John Laing, an infrastructure development and management company, have been recent targets for such activity. Luke sold both these positions at a profit and said he would not be surprised if other portfolio holdings also became subject to M&A activity.

The manager is confident that the UK market’s discount to other markets will close over time, and he is therefore very comfortable maintaining the trust’s long-term focus on high-quality companies capable of sustainable earnings and dividend growth. The manager’s confidence in the trust’s long-term prospects is manifest in the fact that he is a shareholder in the trust and has recently added to his holding.

Luke is also confident of MUT’s ability to maintain its long-term record of dividend increases. His focus on quality companies meant that portfolio income proved relatively resilient during the pandemic, declining by only 13% in 2020, much less than the 44% fall sustained by the UK market. The trust’s portfolio income saw an 11% recovery in 2021 and the manager now expects dividend receipts to reach new highs this year. Such an outcome would exceed the trust’s forecasts as well as dividend receipts across the broader market. Link, a consultancy which monitors dividend payouts, estimates that dividend payments during 2022 will still be 21% below 2019. The positive outlook for the trust’s dividend receipts will ensure the board is well-placed to deliver on its commitment to pay a dividend of at least 34.75p per share in FY22, up from 34.50p per share in FY21, as foreshadowed in MUT’s Annual Report (see Dividend section for more detail).

Current portfolio positioning

While the recent rotation out of quality and growth stocks has had an adverse impact on MUT’s near-term performance (see Performance section for details), it has provided Luke with the opportunity to buy the kind of high-quality, strong growth names he targets, at more attractive prices.

Several recent acquisitions and top-ups to existing positions are housing related. The manager has opened a position in Watkin Jones, a market-leading property developer of homes for rent and purpose-built student accommodation. The company’s activities in both these markets have a strong track record and ‘significant long-term growth potential’, says Luke, as institutional investors are expected to continue increasing their exposure to these kinds of assets. The manager also likes Watkins Jones’s capital-light approach, by which projects are forward funded by institutional investors. The company has an extensive pipeline of developments and high barriers to entry related to its expertise in planning and land sourcing, and its relationships with clients and other key stakeholders. Luke believes that Watkins Jones’s earnings growth, very strong net cash balance sheet and quality characteristics are greatly under-appreciated by the market, given its modest P/E valuation ratio and attractive dividend yield. The manager has also added to the trust’s existing positions in Marshalls, a supplier of building materials, and Homeserve, which provides home repair and improvement services, and topped up its exposure to OSB, a UK mortgage financier, whose strong capital position has led to a significant dividend increase.

Aside from OSB, other financial names also feature among recent purchases. OCBC, a Singaporean bank with a strong balance sheet, high returns and an attractive dividend, is the most recent addition to MUT’s foreign holdings (Exhibit 3). As a reflection of the manager’s expectation of persistent strength in M&A activity in the UK market (discussed above), the trust participated in the initial public offering (IPO) of UK private equity firm Bridgepoint. Luke likes this business’s experienced management team and good client relationships. He has also added a new position in Hiscox, a diversified international property and casualty insurer, as he believes this stock is undervalued given its robust capital base and the strength of its retail business, which represents 75% of earnings. The company should also benefit from the higher interest rate environment. Elsewhere, a dip in the share price of Experian, a credit rating agency, provided the manager with the opportunity to re-open a position in this name, which he views as a ‘very strong business with high margins and pricing power, coupled with strong long-term growth potential’.

The other recent portfolio acquisition is Drax, a producer of renewable energy, which should benefit from higher power prices and offers an attractive dividend yield. The manager also sees upside potential for the company to profit from developments in the bioenergy with carbon capture and storage (BECCS) sector. This process extracts energy from wood, agricultural and other biowaste products, capturing and storing carbon, and thereby removing it from the atmosphere. This process is garnering much attention from environmentalists and the renewable energy sector, and now has political support. Companies such as Drax, at the forefront of this technology, should be well-positioned to capitalise on their first-mover advantages. Luke has also added to MUT’s positions in Sage, a software publishing company with good growth prospects, high and growing margins and a strong balance sheet, and Moonpig, an online greeting cards and gifts retailer.

These purchases have been funded in part by profit-taking to trim several positions that had performed strongly and where valuations looked less attractive. Names include Dechra Pharmaceuticals and VAT Group, a Swiss manufacturer of vacuum pumps. Exposures to BHP, a metals and mining company, and National Grid, a utilities company which manages the UK energy system, have also been reduced, along with a position in Fever-Tree Drinks. Despite downgrades to Fever-Tree’s sales projections, which have weakened Luke’s conviction in the name, the stock was still valued at a premium, so Luke took the opportunity to trim exposure. The share price has since declined sharply. The purchase of Experian in March was funded by trims to positions in AstraZeneca and Standard Chartered, which have performed well, and Prudential and Bodycote, which have lagged.

In addition to the outright sales of Sanne and John Laing due to takeover bids (discussed above), other recent full disposals have included mining company Rio Tinto, following revelations of systemic bullying within the organisation. Proceeds of this sale were invested in Anglo American, another mining company and now a top 10 holding with a lower dividend, but better growth prospects.

At the end of March 2022, MUT held overweight exposures to utilities, real estate, industrials, technology and healthcare, while its largest underweight was to financials (Exhibit 2). This underweight is motivated by the manager’s view of the quality characteristics of many stocks in the sector. The trust’s ESG focus meant that it also had a notable underweight to energy, and it had lesser underweights to consumer staples and consumer discretionary, sectors that tend to be home to lower-quality, lower growth stocks.

As well as being well-diversified by sector, MUT is also diversified by market cap size and by geography. Around 30% of MUT’s portfolio is invested in the UK’s vibrant mid-cap companies, which have outperformed UK large caps and the world market decisively over the past decade. In addition, 13.3% of the portfolio is invested in overseas stocks (Exhibit 3). This exposure to international companies provides the trust with access to industries not available in the UK market. Luke cites the example of VAT Group, a specialist industrial engineering company which is the global leader in high-end vacuum valve technology, with over 50% market share. This sector has high barriers to entry, and ’very strong’ long-term growth drivers, says Luke, thanks to demand from the manufacturers of electric vehicles, 5G products, robotics and cloud computing and storage.

MUT’s manager also uses option writing to provide the portfolio with an alternative, independent source of uncorrelated income. Typically, 75% of MUT’s option positions are covered calls, with positions determined by valuations and/or portfolio weightings. The portfolio currently has 11 covered call option positions (compared to 12 in December 2021), comprising 3% of the portfolio. Positions included calls on AstraZeneca and Diageo (the trust’s top two holdings at end March 2022) and Standard Chartered bank.

At the end of March 2022, portfolio holdings totalled 65, up from 61 at end March 2021. Gearing was at 9.8% on 13 May 2022 (up slightly from 9.5% at end November 2021), a reflection of Luke’s confidence in the outlook for the portfolio.

MUT’s high-quality, growth-oriented holdings have lagged during the recent rotation into lower-quality cyclical and value stocks. In the six months to end April 2022, MUT returned -2.6% on a NAV basis and 0.3% in share price terms, underperforming the UK market (represented here by the CBOE UK All Companies Index), which returned 3.7%. The trust also underperformed over the year to end April 2022, but has outperformed over three, five and 10 years (Exhibit 5, right-hand side). Over the 10-year period to end March 2022, MUT has made an average annualised return of 8.1% in NAV terms and 7.7% on a share price basis, compared to an average annualised market return of 7.2%. The trust has also outpaced the MSCI UK High Dividend Yield index over three, five and 10 years, although it has lagged the MSCI AC Index. MUT’s performance has outpaced the averages of its AIC sector peers over one, three and five years (Exhibit 6).

The trust has also delivered strong risk-adjusted returns, as measured by its information ratio (IR), which measures investment returns generated for each unit of risk taken, compared to the benchmark. An IR up to 1 is considered a good result. MUT’s IR in the three years to end February 2022 was 1.36, which compares favourably with its peers. In recognition of this, in November 2021, MUT received the Citywire award for the UK equity income investment trust with the highest risk-adjusted returns over a three-year period. This is the second year in a row that MUT has been recognised with this accolade.

The manager’s asset allocation decisions at the sector level detracted from returns in the six months to end March 2022. Its underweights to energy, financials, telecommunications and consumer staples and its overweights to industrials, technology and healthcare detracted. However, a modest underweight to consumer discretionary, combined with overweights to utilities and real estate, enhanced returns over the period.

Stock selection was the main adverse influence on returns over the review period, with the largest negative impact coming from three stocks that MUT did not hold, but which performed well. These included oil producer Shell and Glencore, the Swiss metals and mining company, which both benefited from stronger commodity prices. HSBC, which gained on anticipation of higher interest rates, also reduced returns. The trust does not own any tobacco companies for ESG reasons and not holding BAT detracted over the period.

The trust’s overweights to Countryside Partnership, a housebuilder, Close Brothers, a financial company, and Aveva, a software applications provider, also hurt returns. Coca-Cola Hellenic detracted due to its exposure to Russia and Ukraine, as did Inchcape, which also operates in Russia. However, Coca-Cola Hellenic has now suspended operations in Russia and Inchcape has begun the process of exiting this market. These names remain in the portfolio.

Holdings that supported performance over the same period included the trust’s out-of-index positions in several overseas companies, including French energy company TotalEnergies, and Novo-Nordisk, a Danish pharmaceutical firm whose innovative treatments for diabetes and obesity are experiencing strong global demand. Overweights to Drax, Safestore, SSE, Standard Chartered and OSB also enhanced returns. The decision not to hold either Flutter, a sports betting and gaming company (formed by the merger of Paddy Power and Betfair), or Barclays, also added.

MUT is a member of the AIC’s UK Equity Income sector, which comprises 20 funds, although it is differentiated from many of the constituents of this sector in several respects. While MUT is focused on companies with high-quality characteristics, several of its peers have a more value-oriented investment approach. MUT’s portfolio is more diversified than some, across sectors, stocks and geographies, as around a third of its portfolio is invested in mid-cap stocks and more than 10% is held in international stocks. The manager also seeks to supplement and diversify income sources with modest option writing.

MUT’s merger with PLI, in November 2020, doubled its market capitalisation, making it the fourth largest fund in this sector (Exhibit 6). It has outperformed the average of its peers over one, three and five years. MUT’s ongoing charge is one of the lowest of its peers following its merger, reflecting a drop in management fees. Its discount is somewhat wider than average, and its gearing is slightly lower. Its dividend yield is also slightly below the average of its peers.

MUT aims to provide investors with a high and growing dividend, paid quarterly in December, March, June and September each year. FY21’s dividend of 34.50p per share was 0.7% higher than FY20’s 34.25p. (The fourth interim dividend for FY21 was declared in August 2021 and paid in September.) As discussed above, this makes FY21 the 48th consecutive year of dividend increases. The dividend was 98% covered by revenue earned. Following this dividend payment, which reduced reserves by £0.9m, or 0.8pp, reserves stood at 12.9p per share (£15.1m) available to support future dividends – equivalent to 37% of the current annual dividend of 34.50p per share.

In early November 2021, the board declared that the three interim dividends for the current financial year ended June 2022 (FY22) will each amount to 8.25p, taking the total to 24.75p, unchanged from the first, second and third interim dividends for FY21. The fourth interim dividend will be declared after the year end and paid in September. MUT’s chairman has confirmed that the final dividend will be at least 10.00p per share. This will take the total dividend for the year to at least 34.75p per share, sufficient to ensure MUT’s dividend payment record remains in place for a 49th consecutive year.

This represents a prospective dividend yield of 4.1%, based on the current share price.