Any personal opinions expressed are the views of the Fund Manager at the time of publication and are subject to change and should not be interpreted as advice or a recommendation.
The UK’s dividend incubators targeting double-digit returns
Generating high and sustainable income in an environment of low growth and low interest rates continues to pose a challenge for investors. We believe many investors are turning to equity income for yield, as fixed income is no longer the obvious source of quality income and prime commercial property appears overvalued.
UK Equity Income fund investors are currently enjoying a run of success, with many funds currently yielding between 4% and 6%. If interest rates remain at levels below 1%, the equity income sector looks likely to remain attractive to yield-hungry investors.
Premium yield from differentiated sources
The Downing Monthly Income Fund (DMI) has a multi-cap investment approach, weighted towards companies at the smaller end of the market. It adopts a high conviction approach to income and focusses on companies targeting a premium yield from differentiated income sources with additional growth prospects. Manager James Lynch believes many of the holdings in the portfolio are ‘dividend incubators’ – companies that can potentially grow earnings and dividends at an elevated rate, resulting in capital appreciation as valuations grow over time. Growing dividends provide an attractive yield on cost, with the two combining to offer the opportunity to earn a compelling total return. DMI targets a compound total shareholder return of 10% p.a. over the long term*.
The fund focusses on dynamic smaller companies that are often under-researched and operate in inefficient markets, presenting a compelling investment opportunity. DMI is a high conviction portfolio of 30-40 company holdings, and targets exposure of around 80% to companies with a market cap below £1 billion. It aims to deliver a premium yield of 4% and above, paid monthly*.
The following companies, listed on the Alternative Investment Market (AIM), are prominent holdings within DMI: Ramsdens (5.2%), Duke Royalty (4.3%) and Lok’nStore (4.7%)**. Below, James Lynch, explains the investment rationale behind each of these portfolio holdings and why he believes they are good examples of the type of ‘dividend incubators’ that he targets.
Duke Royalty - first mover advantage
Duke Royalty is a first mover into the European royalty finance market. This is a well-proven model in the United States and Canada that has allowed early investors to achieve an average capital gain of 1334% and a yield of 32% on the IPO price (as at 14 October 2017).
Royalty financing is designed to offer private business owners a source of long-term capital without suffering refinancing risk or any loss of control. With £1.2 billion in deal value being evaluated, Duke has demonstrated that there is clear demand for this product. From this, a near-term pipeline of around £75 million has been identified (as at October 2017). The company aims to de-risk its exposure to underlying businesses by seeking opportunities that have asset backing, a five year track record of visible revenue generation and little or no debt.
After completing due diligence on the underlying royalty partners, DMI has taken a 5.16% position in the equity of Duke Royalty. This is a significant position, equivalent to around 4% of the portfolio.***
Our forecasts suggest that we can expect an initial yield of 6.3% growing at a compound rate in excess of 30% over the next two years, resulting in a yield on cost of 8.8%. This compelling asset-backed income story is reinforced by our projected return on equity of close to 10% and robust earnings growth. We believe that there is significant upside potential to our current forecasts and Duke Royalty is expected to remain a core holding within the portfolio for the medium to long-term.
Ramsdens - overlooked organic growth
Ramsdens is a growing and diversified financial services provider and retailer. It operates in four core business segments, including foreign currency exchange, pawn broking loans, buying and selling precious metals, and retailing of pre-owned and new jewellery. The Group operates from 127 stores located in the UK.
There are a number of attractive elements to the investment case: the defensive business mix, high levels of cash generation, net cash balance sheet, barriers to entry provided by the regulatory environment, and a strong and prudent management team. However, we believe the key to our investment has been the wider market’s misunderstanding of the Group’s true growth potential.
Firstly, assumptions have misjudged the organic growth that can be achieved from the existing estate by some margin. The FX, retailing and pawnbroking businesses have grown at annualised rates of 37%, 25% and 7% respectively, and should continue to grow at good growth rates. We have made prudent assumptions around these growth rates but our forecasts are still materially ahead of the market. The second route to organic growth is through opening more stores. Ramsdens has grown the estate by approximately 12 new stores each year since 2002. Based on management’s strategy, and the historic rollout pattern, it would be fair to assume that the Company targets a similar level of openings per year over the next 10 years, however the market has assumed far fewer. It appears both the rollout potential and the contribution a mature store can make to profitability has been misinterpreted - we believe a mature store could contribute twice as much as assumed by the market.
Downing managed funds cornerstoned the placing of private equity stock in December 2017 and we now hold 14.97% of the underlying equity across our portfolios. DMI has a 5.2% allocation, making Ramsdens the largest holding in the portfolio as at 29 March 2018.
Ramsdens is a great example of a dividend incubator; we expect it to grow both earnings and dividends at an accelerated rate.
Lok’nStore - proven dividend incubator with a sustainable competitive advantage
Lok’nStore is a leading player in the UK’s fast-growing self-storage market. It opened its first self-storage centre in February 1995 and has grown consistently over the last 20 years. The Group now operates 26 self-storage centres and two serviced document stores in the south of England.
Since July 2009 the business has shown annualised share price growth of 31% in each financial year, and has also grown the dividend at an annualised rate of 33%, for a total shareholder return of 738%. Lok’nStore’s large weighting within the DMI portfolio is justified by its healthy pipeline, asset-backed estate and positive outlook.
The company has several key characteristics that we believe make it a good example of a typical dividend incubator. In addition to its strong and increasing asset base, the self-storage business is highly cash generative with high profit margins on established stores and all customers paying on a rolling 28-day basis. Lok’nStore also has a track record of strong and growing cash generation driving a progressive dividend policy and significant growth in third-party management services should increase the levels of return on invested capital.
Dividend incubators will reward patient investors
We believe DMI has a differentiated approach to income investing, choosing to focus on smaller businesses whose efficient operations and strong balance sheets allow them to pay secure and growing dividends. Duke Royalty, Ramsdens and Lok’nStore are great examples of small UK companies whose potential have bee…n misinterpreted by an inefficient market. And as dividend incubators, they should continue to provide patient investors with attractive returns over the long-term.
Manager, Downing Monthly Income Fund
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Important notice: this is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. An investment should only be made based on the relevant product literature. The value of investments and any income derived from may go down as well as up and investors may not get back the full amount invested. Where any estimates, forecasts or projections have been made, these are what the Fund Manager believes to be reasonable as of the date of this document. Any statements may involve known or unknown risks, uncertainties and other important factors, which could cause actual performance to differ from those expected, as such they are not reliable indicators of future performance and should not be relied upon. Past performance is not a reliable indicator of future results. We recommend investors seek professional advice before deciding to invest.
*Please note, this is target only and is not guaranteed
**MI Downing Monthly Income 29/03/18
***MI Downing Monthly Income Fund as at 29/03/18