How we yield 7% investing in the UK equity market

One of the highest-yielding funds or investment trusts focusing on the UK equity market is abrdn Equity Income Trust Ord (LSE:AEI).

Thomas Moore, its fund manager, tells interactive investor’s Kyle Caldwell how it achieves a high yield, names three income stocks it's favouring at present, and explains why the bulk of the portfolio is in overseas earners.

• Research: Top Investment Trusts | Sustainable Funds List | Top UK Shares

Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today in the studio I have with me Thomas Moore, manager of abrdn Equity Income investment trust. Thomas, thank you for coming in today.

Thomas Moore, manager of abrdn Equity Income Trust: Hi Kyle, good to be here.

Kyle Caldwell: So, Thomas, to start off with, could you give an overview of your investment process and could you talk us through the key qualities that you're looking for when investing in UK dividends?

Thomas Moore: Right, well, that starts with the investment objective. So, we're looking to achieve an above average yield. So, I want high yield, but I also want growth. I want dividend growth. And over time, I also want capital growth. So, the types of companies that we select for our portfolio need to fit those criteria. And at the moment, we're finding lots of companies that are generating lots of cash, and using that cash to buy back their shares, pay dividends and also invest in the future of their companies.

Kyle Caldwell: We've seen that over the past 12 months, UK stock market performance has been fairly choppy, but we have seen some strong short-term periods as stock markets have reacted to the prospect of lower interest rates. Has that been the key driver? Or has there been more to it?

Thomas Moore: Yeah, the last 12 months. Wow. I mean, what a roller coaster we've seen. We saw a sharp improvement in the performance of stock markets in the run-up to the general election. And if you think about the reasons for that, the first reason was actually interest rates were thought to be coming down quite dramatically, and then second, people were looking ahead to potentially a period of greater political stability.

Now, after the general election, a couple of things have happened. First, inflation has proved quite sticky. So, interest rate expectations, although we're still expecting a couple more base rate cuts, it used to be four or five base rate cuts that people were expecting. So, that's one big change. The economy's gone a bit slower recently, so we've had disappointing GDP growth data.

People are debating whether that's linked to all the uncertainty around the UK Budget. Rachel Reeves came out at the end of October, and there were some tax rises in [the Budget] that didn't go down too well, and some increased borrowing, which have had the effect of increasing bond yields. So, there's all of that into the mix.

And obviously on top of that, you've had the election of Donald Trump, which has given the US market a boost. Of course, people can invest wherever they see opportunities, and a lot of people are looking at the US and deregulation, cheap energy. They're looking at the growth agenda that Trump is offering and they're comparing the US against the UK now.

We believe there are some great opportunities within the UK, but short term, that debate between US growth and the UK in a period of difficult economic times, it's becoming a difficult choice for investors.

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Kyle Caldwell: For a number of years now, commentators have pointed out that the UK stock market is cheap. Does it remain cheap, and how cheap is it?

Thomas Moore: I would answer that in two ways, Kyle. The first way I'd answer that would be that certainly in terms of international companies, it's actually really easy to do the comparison. You can do the compare and contrast, look at different sectors, and you see some pretty similar companies.

So, let's think about Exxon Mobil Corp (NYSE:XOM) versus Shell (LSE:SHEL), for example. Or, if you look at different sectors, you can do the same kind of comparison, and you'll find that in every case, the UK name is trading at a much cheaper valuation than the international name. Now we see that as an opportunity. So, we've got around 55% to 60% of our portfolio in names that are overseas earners. So, we've got the bulk of our portfolio overseas and we're seeing lots of attractive investment opportunities in those areas.

Now on top of that, we are also seeing some opportunities in the UK domestic area. Now that's where they're really bombed-out valuations. We have to be careful there, though, because the valuations can stay low.

We're always aware of the risk that a company can look cheap, but if things don't improve, there isn't really a catalyst for that stock and the valuation to re-rate. So, we're looking at UK domestics, but we're being very selective given the growth outlook, as I said earlier, is mixed at the moment.

Kyle Caldwell: The investment trust has a yield of around 7%. So, when you're looking to invest in companies that are paying a high yield, how are you avoiding the potential value traps?

Thomas Moore: Yeah, that's a really important question. So, for me, what's really important is that we focus on companies generating lots of cash that will allow them to invest in their businesses, but at the same time hand some of that cash back in the form of dividends and buybacks. And we see that as excellent news for the share price as well.

Our view is that income and capital can and should go hand in hand over time, and we believe that's been borne out by the evidence over the last 12 months, as lots of companies that we selected have delivered on cash flow, they've delivered on dividends, and the share prices are finally responding after a long period of waiting post-Covid.

I should also add that gearing helps us with that 7% dividend yield because we've got a gearing facility, which is about 13% at the moment. That gives us a bit of extra ammo to be able to deliver that 7% dividend yield.

Kyle Caldwell: And could you talk us through some of the highest-yielding stocks that you own?

Thomas Moore: Right. I think the best place to start to answer this question is the largest position in the portfolio, which is Imperial Brands (LSE:IMB), the tobacco business.

So, I would say, first of all, that if you cast your mind back three years, four years, the shares were trading somewhere between £12 and £14, and today they're trading in the mid-twenties, so about £24, £25. So, it's moved a very long way in a very short space of time.

Now, if you asked people back in 2020, 2021, what they would think the prospects of this company would be, they would tell you it's a value trap. You know, it's ex-growth, it's not a sexy business. But the chief executive came along, looked at how much cash this company could create for shareholders if they just focused on a fewer number of brands, a fewer number of products. So, slim the portfolio down, get the business humming. That's what he's done. He's delivering the cash. It's coming through in the form of dividends.

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Now, if you think back, this company's not skipped a beat in terms of dividends. They're still yielding 6%, but obviously the share price has gone up a lot over the last four or five years. So, back in the day when people were writing this company off, this company would have been yielding 11%, 12%, and people would have said, look, that's unsustainable. Well, it was sustainable.

So, I think that's a good example of how we can take on the market. We can say, look, sometimes share prices are too low and it's then when we need to be stepping in and making these positions large enough that they're going to make a meaningful impact on the performance of the wider portfolio.

So, that's what we've done with Imperial Brands still the largest position. We like the 6% yield. They're also doing a similar amount of buyback. So, if you add up the dividend yield and the buyback, you get to about 12% of the company's market cap being returned each and every year.

Kyle Caldwell: And could you pick out another stock example, potentially one that is a more domestically focused UK business?

Thomas Moore: The one I'd pick, which is a domestic, would be Galliford Try Holdings (LSE:GFRD). This is a UK mid-cap construction business. The market cap of this business is only about £380/£390 million, so it's a minnow. But of course, it's a very important company. They provide roads, infrastructure, schools, hospitals and all the ancillary services to industries, the UK public sector and the private sector.

I'd say that one particular industry, which is particularly important at the moment, is water. As we know, they're in the headlines far too often, the water companies, for all the sewage leaking out into rivers, into the sea, there's a huge amount of infrastructure work that's going to need to take place in the next five to 10 years. And companies like Galliford Try are right at the forefront of that investment.

And of course, look, there's only a limited number of companies with the capability, with the skill set to be able to deliver that investment for the sake of the UK population, because we all want to be able to swim in the sea.

I don't know about you [when it comes to] checking the Surfers Against Sewage website. I spent half my summer doing that. I want to be able to swim in the sea without having to worry about sewage. So, Galliford Try are at the forefront of that. I think that's fantastic for the UK that we have these providers who can do that.

Now what's happening is their operating margin is eking up. Year by year, they're delivering a rising amount of revenues, but they're also delivering a rising operating margin because the competition is tighter than it was 10 years ago. Companies are more disciplined when they're pricing for these contracts.

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Kyle Caldwell: And if I have to push you for a third high-yielding stock, what would you name?

Thomas Moore: I have to mention NatWest Group (LSE:NWG). I think NatWest is a bank that is really well positioned for this environment that we're entering into. I mentioned earlier about interest rates. Look, interest rates are going to remain higher for longer. We will get another base rate cut, maybe two base rate cuts, and yes, that will stimulate demand short term, but the fact is there's a lot of borrowing going on.

The gilt issuance in the next five years is meaningfully higher than people had anticipated even six months ago. So, in order to issue those gilts, the government is going to have to price the bonds appropriately. That means gilt yields will be higher.

Now, what the big banks do is they take our deposit money and they park it in gilts, so they generate a very nice spread between what they pay us on our deposits and what they generate on those gilts. And that is called their net interest margin.

Now that is pretty visible. That's pretty predictable revenues for NatWest. So, for me, I'm looking at the current environment and I'm seeing the economy going through a period of interest introspection. We've got relatively stagnant economic growth at the moment. That doesn't matter for NatWest, their generating lots and lots of interest income. So, for me, that's the important driver and that's why I've made that a meaningful position in the portfolio.

Kyle Caldwell: You touched on earlier the fact that investment trusts have the ability to gear, which is borrowing to invest. How do the current gearing levels compare to normal?

Thomas Moore: Well, currently we're running at 13% gearing, and that's within the range. Typically, we're between about 10% and 15% gearing. Now, obviously, you could try to market-time, but our view is that actually over time, economies will grow, company earnings will grow, and dividends will grow.

And, actually, if we can have that additional gearing facility that enables us to be more exposed to that stream of growing earnings and dividends, which should be in the interest of our shareholders over time.

Kyle Caldwell: Thomas, thank you for your time today.

Thomas Moore: Thanks, Kyle.

Kyle Caldwell: So, that's it for our latest Insider Interview. We'd love to hear from you. You can comment, you can hit the like button and also the subscribe button for more videos from fund managers. And hopefully we'll see you again soon.