Schroder Income eyes potential merger ahead of continuation vote

Schroder Income Growth (SCF ) says it will not rule out a merger ahead of its continuation vote next month, as it continues to battle a UK market heavy on buybacks and light on dividend growth.

The £245m UK equity income portfolio delivered a net asset value (NAV) total return of 9.6% in the year to the end of August, lagging the FTSE All-Share’s 12.6% rise. Shares in the trust, however, were up 12.9%, reflecting a narrowing of the discount.

A rally in the UK market may come just in time for the trust, which faces a continuation vote next month. Chair Ewen Cameron Watt urged shareholders to back manager Sue Noffke, who has outperformed the FTSE All-Share by 29.9 percentage points since her tenure began in 2011.

However, he noted there is ‘much talk about the benefits of greater size of investment companies’ and the board was ‘not blind to the argument that there are too many competing funds in sectors, including UK equity income, to allow for differentiation and therefore the possibility of future shrinkage in the number of funds’.

‘We simply believe that this process should be driven by considerations of potential returns per share,’ he added, noting that the board had a duty to shareholders to assess any approach regarding a takeover or merger.

Dividend delight

The board stuck to its progressive dividend, increasing the payout by 3.5% to 14.7p for the year, despite earnings falling below the dividend over the period. Although earnings from holdings were up 7.88%, they only reached 12.55p per share, meaning the dividend was just 0.85 times covered.

This meant the fund had to dip into its revenue reserves to make up the shortfall, which now totals £4.3m, equivalent to five months of the annual dividend.

Earlier this year, the trust introduced a package of measures aimed at discount control and improving shareholder returns, including smoothing the dividend distribution.

However, Watt noted that a change in ‘environment for income generation’ made it ‘more challenging for dividend income alone to bridge the gap between earnings per share and the dividend level sought by the board’.

This gap has been driven by companies becoming more prudent as they tackle higher financing costs, with lower payout ratios, a focus on share buybacks rather than dividend increases, and a lack of special dividends as companies.

This is not the first occasion the trust has used revenue reserves to top up the dividend, but Watt said ‘the board is mindful that using these reserves must be approached prudently and is not a substitute for growing underlying income’.

Ahead of the continuation vote, Watt said there is an ‘excessive focus on revenue reserves in assessing prospects for such growth’.

‘Most major investment sectors focus on pay outs to their beneficiaries based on total return, which is capital plus income received,’ he said.

‘We agree with this approach, taking the view that all reserves generated from investment returns are available for shareholders. As such we note that future dividends for your company should logically be based on total distributable reserves.’

This includes capital reserves of £208m plus revenue reserves, as well as earnings inflows.

‘We do not believe that your best interests are served by buying the highest yielding shares in the market irrespective of their ability to grow dividends and history supports this belief,’ he said.

Shopping for consumer staples

Noffke, who was briefly joined by Matthew Bennison as deputy manager before he left after just two months in July, said there was a ‘modest but welcome return to growth’ this year.

This growth was driven by the financial sector, including double-digit increases from Natwest, Standard Chartered, 3i, XPS Pensions, and Prudential.

Outside of the sector, Cranswick, Tesco, Haleon, Telecom Plus, and BAE Systems paid dividends all in double-digits.

Noffke said the increased investment in smaller companies is ‘yet to pay off’ as mid-caps are still ‘displaying volatility since their mid-2021 peak’.

There was plenty of change in the portfolio over the year, with 15 new holdings offset by 12 exits.

This includes four new consumer staples, including drinks giant Diageo, which was reintroduced after share price weakness.

Noffke said ‘near-term profit expectations have been reset, with the destocking cycle advanced, suggesting sales recovery is possible’.

Fever-Tree, the premium mixer maker, was also added following its distribution deal with Molson Coors which provides ‘capital growth potential in the US’.

Supermarket behemoth Tesco was purchased for its ‘attractive income generation and 4% dividend yield’.

‘Its competitive position supports market share gains and targeted promotions, potentially yielding high-margin advertising revenues,’ she said.

Primark owner Associated British Foods is benefitting from growth at its budget clothing stores and Noffke said management ‘can unlock further value by streamlining and addressing underperforming divisions’.

While the UK market is still broadly out of favour despite a rotation out of the US, Noffke said ‘momentum is building in domestic policy, with new initiatives to foster long-term investment and reinvigorate the UK’s capital markets’.