Dan Whitestone, manager of the £385 million BlackRock Throgmorton (THRG) trust, says he is seeing an ‘alarming’ number of companies paying dividends they cannot afford.
‘There are some companies that have this correlation between paying these dividends and underinvestment,’ he said.
‘We think this is really dangerous and we've met CEOs and boards who are caught because obviously there are income investors who tell them they really, really want a dividend, and they know that if a dividend gets cut their shares might fall because income investors sell them.
‘Well if that is your priority as a CEO, we think that is very worrying.’
Throgmorton’s portfolio is made up of small and mid-cap companies, focusing mainly on disruptors of their respective sectors and reinvesting gains in the business for capital growth.
Whitestone therefore believed it was unsustainable for companies to ‘keep on robbing Peter to pay Paul’ and depriving a business of reinvestment.
‘When you've got nothing else to pay out the dividend with, then you're forced to cut the dividend, often that can go hand-in-hand with emergency recapitalisation and we've seen quite a few high-profile examples of that in the stock market in the last few months,' he said.
‘I think that's a worrying trend I really do but a trend we can make money out of by avoiding these and shorting them. We're short quite a lot of companies that pay dividend yields but can't afford them.’
Marks & Spencer (MKS) recently cut its dividend, prompted by its tie-up with online supermarket Ocado (OCDO) – the stock’s dividend yield had escalated from 4% to nearly 7% in the last five years as its share price fell as investors doubted its prospects.
British Gas-owner Centrica (CNA) and telecoms business Vodafone (VOD) have both been tipped by analysts as high-yielders in line for a dividend cuts amid financial pressures – they currently sit on yields of 11% and 9% respectively.
Collecting on Conviviality collapse
Around 15% of the Throgmorton portfolio is weighted to ‘short’ positions in stocks where the manager seeks to make money betting that a company’s share price will fall. Whitestone has been active in this area with the allocation to shorts rising from 10% in the middle of last year.
Whitestone alluded to Bargain Booze-owner Conviviality as an example of the trust’s success in identifying companies showing signs of trouble, as the short position acted as the top contributor to returns in 2018.
Conviviality collapsed in April 2018 after issuing two profit warnings, revealing earnings forecasts had been overstated by £5.2 million and that an ‘arithmetic error’ meant a £30 million tax bill had been overlooked.
Whitestone opened the short position in Conviviality after starting to question the rationale behind an ‘extremely large acquisition’ – it doubled its size with the purchase of drinks wholesaler Matthew Clark in 2015 – which was funded by a ‘huge amount of debt’. The position contributed to more than 0.4% to performance in 2018.
Last year, Throgmorton’s board scrapped the trust’s dual structure, which had seen Whitestone manage a separate derivatives – or, contracts for differences – portfolio alongside the book of smaller company shares, run by Mike Prentis.
The changes were implemented as Prentis stepped off the trust, handing the reins to Whitestone, as the board looked to simplify and differentiate Throgmorton from its sister trust BlackRock Smaller Companies (BRSC).
Another change that was implemented in the shake-up was allowing Whitestone to invest up to 15% of the portfolio overseas.
Whitestone said this enabled him to invest in the likes of Xero (XRO.AX), an Australian accounting software business using cloud technology to challenge the stronghold of legacy incumbents like Sage (SGE).
Xero, which represented a 1.9% position in the trust in November, was the ‘poster child of emerging companies’, said Whitestone.
‘[It has] a huge runway of growth when you think that at the vast majority of small businesses in the UK, which is where they have a very strong position... are still using spreadsheets,’ he said.
Since the trust’s overhaul Throgmorton’s discount has narrowed from 14% to 5%.
‘The trust’s discount has narrowed significantly since the referendum in 2016 – when it reached a 22% discount at one point - and we have continued to see it narrowing over 2018 and 2019 ytd,’ noted William Sobczak, investment trust analyst at Kepler Partners.
‘Given the company invests in one of the most out of favour sectors across the globe, the trust had a relatively strong year in 2018.’
In the past 12 months Whitestone has managed to minimise the impact of volatile markets with Throgmorton’s net asset value including dividends slipping 2.7% versus a fall of 5.3% in its Numis Smaller Companies plus AIM (ex ICs) benchmark index. However, because of the improved rating on the shares, total returns to shareholders have been positive, up 3.7%.
This has maintained its strong track record which has seen the trust generate a 103% total shareholder return, well ahead of the 67.3% average in the highly competitive AIC UK Smaller Companies investment trust sector.