Q&A: Multi Cap Income investment update

FE fundinfo Alpha Manager Sid Chand Lall, Manager of our Multi Cap Income Fund, highlights the value of dividends in a range of market scenarios and explains how he has been taking advantage of market volatility to invest in high-quality companies at significantly lower valuations.

Markets are facing a number of headwinds, with higher inflation, rising interest rates and lower economic growth. How important do you expect dividends to be for investors in this market environment?

“Companies are facing considerable challenges as a result of the Ukraine conflict and the lingering effects of the pandemic. This uncertainty is clearly being reflected in markets, which have sold off significantly this year. In this sort of environment, dividends can play a very important role for investors as a source of steady returns during market volatility.

“There’s a broader point to make too, which is that dividends can make an important contribution to returns in a wide range of market conditions. When equity markets sell off, the income from dividends means investors get paid to wait for markets to recover. When equity markets are making modest gains, then a dividend yield of more than 4%, which is what we’ve generally delivered historically (although this is not a forecast or guarantee), can make a very useful contribution to the total return. Then, in a scenario where equity markets bounce back and returns are strong, dividend income can still enhance the total return via compounding growth when reinvested. So, we see dividends as playing an important role across a range of scenarios.”

The fund has paid a higher dividend yield than the FTSE All-Share in every year since launch. How have you achieved this?

“Ensuring companies are paying healthy and, in many cases, growing dividends is absolutely central to our investment strategy. That’s how we’ve managed to beat the yield of the FTSE All-Share every year since the fund was launched in July 2011. It hasn’t always been easy, so we’re proud of our track record. It’s worth pointing out too that we haven’t just narrowly beaten the index yield. It’s always been by a comfortable margin.

“It comes down to a disciplined investment process. We’ll tend to hold companies with a minimum dividend yield of 2%. Some of our companies pay a steady and attractive yield of 4% or 5%, while others are on lower yields, but make up for it with stronger dividend growth.

“We had to take a more flexible approach to dividend yield during the extraordinary times of the pandemic, of course. Even then though, it was interesting to see how many of our companies managed to maintain and even grow their dividends through the crisis – companies like Intermediate Capital, Safestore, Chesnara, Severn Trent and Drax are examples. That’s a broad spread of high-quality dividend paying companies diversified by size and sector, which is exactly what our fund is all about.”

Small and mid-cap companies have fallen out of favour with investors during this year’s market volatility. How has this affected the fund’s performance?

“It’s absolutely correct that small and mid-cap stocks sold off rapidly this year and because we favour smaller companies this impacted the fund’s performance. Our limited exposure to commodities didn’t help (even if it meant we were rated well for ESG by Sustainalytics) because that sector had a very strong first quarter. However, one need only look at the ability of this fund to recover historically. We stuck to our investment process post the EU Referendum in 2016 and also after the steep falls caused by the pandemic in 2020. In both cases the fund recovered and went on to achieve record highs.

“Looking ahead we’re more bullish. We’re confident in our investment process and that, at current valuations, the strong growth potential of our portfolio companies is substantially underappreciated. So, when markets begin to recover the upside potential for these stocks is considerable.

“For investors taking a mid to long-term view, we believe our fund represents a very attractive opportunity.”

What are the advantages of a multi-cap income strategy in an inflationary environment?

“While a fund focused solely on the FTSE 100 would only have 90 or so dividend-paying stocks to choose from, we have an investable universe of around 700 companies, of all sizes, from which to select the most attractive opportunities. That means we can identify well-managed companies that have strong prospects and are committed to growing their dividends. These increasing dividends can be very useful for investors seeking to reduce the impact of inflation on their portfolios.

“Our experience is that smaller companies are more likely to deliver the dividend growth we look for, and that’s because they tend to be expanding and increasing their earnings at a faster rate than larger businesses. This was borne out by the Q1 2022 Link Group Dividend Monitor report. It showed mid-cap FTSE 250 dividends (excluding specials) up just over 30% year on year, while FTSE 100 dividends were up just under 13%, after adjusting for specials and the departure of mining giant BHP, which switched to a single listing in Australia.

“Paragon Banking Group is a good example of a mid-cap company delivering strong dividend growth. Its most recent interim dividend was up just over 30% on the previous year. Another example is Pets at Home. The retailer’s most recent final dividend was up 36% year on year and it’s forecast to increase dividends by another 10% this year. Self-storage company Safestore recently increased its interim dividend by 25% year on year and is forecast to grow dividends by another 10% this year.

“So, you have stronger potential for dividend growth from small and mid-cap companies, which we favour in the portfolio, and our multi-cap approach also provides important diversification benefits. There’s a high level of dividend concentration in the UK market, with 15 giants accounting for 78% of the total dividends paid. A portfolio heavily exposed to this limited number of companies could face considerable stock-specific risk. We prefer to have a much more diversified portfolio. We hold around 120 companies and they represent a really broad spread, both in terms of size and business sector. We have a core investment team of four working on the fund, which means we have the resources to cover this number of stocks, and we also have the support of the wider UK equities team.”

Where are you identifying particular opportunities at the moment?

“We take a highly selective approach, but we’re still identifying very interesting opportunities. The sell-off has been pretty indiscriminate and it’s enabling us to invest in quality companies on valuations significantly lower than they were a year ago. Businesses paying healthy dividends, with high-calibre management and strong prospects, are on Price/Earnings multiples in single figures or barely into double digits.

“One new investment we’ve added to the fund recently is Kitwave, which is a wholesale food and drink supplier. It’s very small, with a “Businesses paying healthy dividends, with high calibre management and strong prospects, are on attractive single-digit Price/Earnings multiples.” market cap of only around £100m, but it serves some major companies. These include the pizza chain Domino’s. Kitwave is a well-managed business, with a strong range of goods and the company has consistently delivered on its promises since last year’s IPO. Kitwave is on a 4.9% yield and forecast to grow its dividends by 13% this year. The company’s on a Price/Earnings multiple of 9x 2022 earnings, falling to 8x forecast 2023 earnings. We think that’s very attractive for a business with such strong growth prospects. Our view is that Kitwave’s potential is being overlooked by investors, largely because of its size.

“We’ve also increased our investment in Renew Holdings, which provides essential engineering services to maintain and renew critical infrastructure, including the rail network, motorways and nuclear facilities. The specialist nature of this work means competition is limited and gives Renew a degree of ‘pricing power’ to pass on rising costs in an inflationary environment. We like the long-term nature of many of the contracts and the fact that the company has net cash available for selective acquisitions. Renew is on a dividend yield of just under 3% and a Price/Earnings multiple of 12x 2022 earnings.

“For investors taking a long term perspective, we believe the indiscriminate nature of the selloff has created some exceptional opportunities.”

Do you believe the Ukraine conflict is influencing ESG considerations?

“What the Ukraine conflict has underlined is that ESG continues to be an evolving area and we can’t rely on simplistic tick-box criteria. For us, ESG has never been a rigid, backward-looking exercise. We look very closely at each individual company using a flexible, forward looking approach and engage consistently and regularly with management teams.

“Defence companies are an interesting case in point. Some investors may have said in the past that on ESG grounds they will not hold any defence stocks full stop. However, Putin’s military aggression in Europe may well have encouraged them to rethink that. We’ve held small positions in selected defence stocks for some time. These are companies that would have scored well on ESG grounds in their own right, either via the ‘S’ or the ‘G’, irrespective of recent events. For example, we hold QinetiQ, which is a defence technology business.

“I think the important point to make is that ESG considerations have always been a factor in our research process, because of their potential influence on a company’s growth, and this focus has grown steadily greater over the years. When we analyse companies, we’ll assess a broad range of environmental, social and governance factors – and these considerations will form an important part of our decision making process. This is why we have never bought the big tobacco stocks.”

How would you characterise the investment outlook?

“Steeply rising inflation and the conflict in Ukraine have created considerable uncertainty in markets. However, once data begins to emerge indicating inflation has peaked, and we begin to see a downward trend, then we’d expect markets to breathe a sigh of relief. It’s also likely to indicate the end of the rate-hiking cycle, which is another positive for most companies.

“Over the next 12 to 15 months, investors are likely to have many opportunities to find mispriced securities. But the market will eventually reset and then we’d expect to see valuations begin to more closely reflect companies’ prospects. In addition, as inflation begins to ease, commodity prices should become cheaper and then we can start to see economies return to their growth trajectories.

“In the meantime, we’re earning good dividends while we wait for markets to recover and using the market volatility to invest in high quality companies at what are, in some cases, remarkably attractive valuations.”

Sid Chand Lall 06/07/22

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