High-yielding stocks hold a dangerous allure for investors. Funding daily operations and expansion, alongside keeping investors happy with beefy payouts, is a tightrope few companies can walk for long. When they fall, shareholders are punished twice, first by the dividend cut and second by the hefty share sell-off that follows.
Focusing too much on the dividend-per-share number risks ignoring the returns that can be made by companies putting capital to work elsewhere. River and Mercantile UK Micro Cap Investment Company should convince investors of as much. The investment trust pays no dividend, but it has delivered a share price return of 133 per cent over a year.
That represents a stunning outperformance of the Numis Smaller Companies index (excluding investment trusts), delivering a total return of 52 per cent during the same period. It is also well above a total return of 23 per cent from the FTSE All-share. Both those figures include dividends too.
The investment trust targets UK stocks that typically have a market cap of less than £100 million at the time of purchase. It is shooting for high, long-term capital growth, which George Ensor, the manager, believes is better scored by backing overlooked micro caps than lumbering giants. Its 38 stocks are tilted towards consumer goods and financial services companies, classic recovery plays.
It is a focus that left the investment trust perfectly positioned to benefit from last year’s shift in investor sentiment from safety towards underappreciated stocks that stood to be pushed higher by a stronger economic recovery. Over the six months to the end of March, it posted a net asset value total return of 39 per cent.
The fall in shares within sectors with more to lose from lockdown restrictions brought more companies into reach for the investment trust. Those included Joules, the retailer, City Pub Group and Revolution Bars.
River and Mercantile Asset Management thinks that the best way to ensure holdings make a meaningful impact on returns is to keep the market cap of the investment trust at about £100 million. When this creeps up it will redeem shares at a price equivalent to the NAV per share a few days prior to the purchase. Since the trust’s inception in 2014 it has handed back almost £77 million to investors, more than the amount raised at IPO.
But not for no reason do small cap stocks usually come with more lowly valuations attached. Shorter track records, lower scale benefits and fewer financial resources are risks more inherent in the businesses themselves. But a lower level of liquidity in the shares also makes them more volatile. For the investment trust, that also means it could be more difficult to quickly shift stock at a favourable price. Winners might deliver outsized gains but the same is true for the damage inflicted by dud investments.
The trust has so far exploited the illiquidity risk premium well. To what extent can that continue? A look at the more distant past is encouraging. Since inception its NAV has increased by 193 per cent net of fees, with the benchmark up just over three-quarters over the same period.
During the first six months of the year it was the number two performer among the entire investment trust universe. However, the shares still trade at a 5 per cent discount to NAV at the start of this month. Private equity firms are hoovering up cheap UK companies, so exposure to lowly rated small caps could prove its worth further.
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Why A more diversified way to gain exposure to companies with recovery potential
PRS Reit
The private rental market is attracting more suitors but there is no risk of overcrowding. Last week Lloyds announced plans to buy and let homes via Citra Living, a new brand, just days after John Lewis revealed plans to redevelop some of its estate and build 10,000 rental homes.
The PRS Reit has a greater history and scale in the sector. It operates rental houses and flats in England, but excluding London, with sites ranging from 16 to 298 units.
Rapidly scaling up the portfolio, which at the end of last year stood at just over 3,000 homes, led to an almost doubling of rental income in 2020. The real estate investment trust plans to reach 5,000 homes by early next year.
Analysts forecast a dividend of 4.24p next year, which at the 107p share price, would equate to a dividend yield of almost 4 per cent.
The removal of mortgage interest relief and mooted changes to the capital gains tax regime have increased costs for private landlords and led to an exodus from the sector. Meanwhile, the affordability constraints that prevent many from getting on the housing ladder have pushed demand higher.
The earnings potential afforded by this dynamic has led investors to, justifiably, warm to the real estate investment trust. Following a rebound since March last year, the shares trade at a 9 per cent premium to consensus forecast NAV at the end of December this year. A low level of defaults by tenants throughout the pandemic would have put investors’ minds at ease.
The entrance of heavyweight institutions into the private rental space might prickle for some. But the reputational risk involved with operating as a private landlord means publicly listed companies such as PRS Reit should also come with greater accountability than one-man bands. But more crucially, the real estate investment trust is adding stock to the country’s chronically starved housing market, rather than just buying existing homes that could have been in the hands of private owners.
As the PRS Reit builds out its portfolio, expect the premium attached to its shares to follow suit.
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Why Demand for rental properties should lead to further rental growth
