This niche income trust has an edge over rivals

And yet this brings various headaches, including the fact that payouts are often concentrated among a few large-caps, and the fear that – by backing a dividend payer with its best days behind it – you will miss out on companies that offer more in the way of capital growth.

The funds universe gives us many ways to skin this particular cat. There are 71 funds in the Investment Association's UK equity income category and 18 investment trusts in the equivalent list from the Association of Investment Companies. The vehicles on offer vary significantly, from the level of yield they target to their use of overseas shares and the extent to which they prioritise small and mid-caps over the big beasts of the FTSE 100.

An unusual business model

Some of the more distinctive portfolios are worth paying attention to, and one name that stands out in the world of investment trusts is Law Debenture Corporation (LWDB).

This trust has an unusual trait that sets it apart from the competition, in that it owns an independent professional services business that focuses on niche areas such as pension trustee services and whistleblowing support. This business has been a source of solid, reliable growth in recent years, and accounts for roughly a fifth of Law Debenture’s net asset value (NAV). Importantly, it is also the biggest contributor to the trust’s income, generating around a third of total dividends.

This means that the investment portfolio, which accounts for the remaining 80 per cent of NAV, does not need to be quite as obsessed with yield as other income trusts. In other words, Janus Henderson investment managers James Henderson and Laura Foll, who run the portfolio, can be more flexible and adventurous in their approach. 

In recent times, this has led them to choose some stocks that have lower yields, or even those that have even suspended their dividends, in a bid to secure strong capital returns. This fits with a self-proclaimed contrarian investment style that involves the managers buying cheap, high-quality companies – “out of favour equities standing at valuation discounts to their long-term historical average”.

A look at the fund's top 15 holdings from the end of October shows that it does have some UK income stalwarts. Note the presence of Shell (SHEL), HSBC (HSBA), GSK (GSK), BP (BP.) and Rio Tinto (RIO), for example. These are names that will help contribute to a share price dividend yield of around 3.5 per cent at the time of writing.

However, other prominent names in the portfolio have little interest in dividends. Top holding Flutter Entertainment (FLTR) currently pays no dividend, having canned payments in 2020, but has seen its profits surge on the back of good growth in the US, helping to drive share price returns of almost 60 per cent so far in 2024.

Other notable recovery plays come in the form of Rolls-Royce (RR.) and Marks & Spencer (MKS). Both companies also dropped their dividends in more challenging times, although they have reinstated payouts this year on the back of robust recovery stories.

Its value-minded approach means that Law Debenture tends to bank significant gains when contrarian picks play out. We have seen that recently with reductions to positions in both Rolls-Royce and Marks & Spencer. "In both cases we continue to hold a position but have taken some profits in recognition that there has been an earnings recovery and the valuation has risen from low levels," Law Debenture told investors this summer.

The team sold takeover target International Distribution Services (IDS) – formerly Royal Mail – and Hipgnosis Songs (SONG) in the same period, while making new investments in Beazley (BEZ), J Sainsbury (SBRY) and office owner Great Portland Estates (GPE). The managers also added to existing holdings such as building materials suppliers Ibstock (IBST) and Marshalls (MSLH), medical device producer Smith & Nephew (SN.) and BT (BT.A).

“There is no end-market commonality to these purchases but in all cases we think they are making operational progress that is not reflected in their current valuation," the managers said in the half year report.

Performance, past and future

Law Debenture’s unusual approach has allowed it to increase or maintain its dividend for 45 years and, as the chart below shows, it has made much better total returns than both the competition and the underlying market. But given some of the team’s recovery plays have already come good, it’s worth asking what will drive future outperformance.

The team has placed a relatively sizeable bet on the recovery of the UK equity market. Although the trust can hold up to 45 per cent of its portfolio in overseas shares, Henderson and Foll have kept the UK allocation at "historically high" levels – 87.9 per cent at the end of October. 

"Despite a positive return (for both the FTSE All-Share and the portfolio) during the six months, UK equities continued to trade at a large valuation discount relative to overseas peers," the team said in the trust's half-year report. "This persistent discount is something we are seeing evidenced in the number of takeover approaches."

The belief in a UK recovery explains a couple of other calls by the investment team. For a start, they have maintained a decent level of gearing, meaning the use of borrowing to put more money into selected investments. Gearing accounted for 9 per cent of NAV at the time of writing, and can amplify gains (and losses) made in the portfolio.

The managers have also been “gradually shifting” the portfolio in the direction of smaller companies that have proved unpopular even though they are doing well on an operational basis. The team added to positions in names such as AFC Energy (AFC), Castings (CGS) and ITM Power (ITM) in the first half of 2024.

FTSE 100 shares accounted for 47 per cent of the portfolio at the end of June, with 23 per cent in FTSE 250 stocks, 9.3 per cent in Aim businesses and 6.2 per cent in the FTSE Small Cap index. This makes the trust far less blue-chip heavy than the FTSE All-Share.

Law Debenture has its downsides. It's not cheap, with the shares trading on a premium of around 1.8 per cent to NAV at a time when wide investment trust discounts are rife. What's more, the 3.5 per cent share price dividend yield compares poorly with that on offer from some peers, and even undershoots the humble 10-year UK government bond.

The hope, however, is that Law Debenture’s flexible, contrarian approach continues to produce the goods, meaning that the modest yield is more than offset by dividend growth and superior total returns. With the caveat that a good run of performance does not guarantee future success, this trust continues to stand out from the rest of the sector.