Juicy Yields With a Growth Kicker

07/01/2009 12:01 pm EST

Focus: GLOBAL

Andrew McHattie

Editor, Investment Trust Newsletter

With UK stocks now yielding more than bonds, one small-cap growth fund looks especially attractive, writes Andrew McHattie in Investment Trust Newsletter.

Over the very long term, the annual rate of return for European equities has come in at around 7%, with the dividend yield being by far the most important component of these returns. According to the Barclays Equity Gilt Study 2009, the real value of £100 invested in equities in 1900 has risen to £139; with gross income reinvested, the figure is a startling £17,571. If you are looking to build long-term capital, you would be unwise to ignore the power of reinvested dividends, it seems.

Right now, JPMorgan argues [that] equities look very cheap on a yield basis, particularly against gilts. Whilst historically the ratio between the yield on a ten-year gilt and UK equities has rarely dipped below 2.0; it is below 1.0 now. A ten-year government gilt is yielding 3.91%. The FTSE All-Share is yielding 4.43%, so the ratio works out at 0.88.

Effectively, the argument runs, investors are being paid more for the risk of owning equities, and any growth prospects are thrown in for free. An unprecedented number of companies offer great yields well in excess of the returns from gilts. Dividend cover is quite healthy at around 2.2 times, which is high against long-term averages.

The strong prospects for dividends, coupled with the low price currently being put on growth, means that it is possible now to combine the two. A case can be made for both JPMorgan Claverhouse (LSE: JCH) at 348 pence with a discount of 3.1% and a yield of 4.7%, particularly as the dividend has risen every year since 1972; and The Mercantile Trust (LSE: MRC) at 779 pence with a discount of 10.3% and a yield of 4.6%. [At Tuesday's closing prices, the JPMorgan Claverhouse had a net asset value discount of 5.5% while the Mercantile was at a 7.3% discount—Editor.]    

The latter is the more attractive of the two. It has a strong short-term and long-term record, ranking first out of 24 UK growth trusts by net asset value performance over the last six months, and eighth out of 20 trusts over the last five years.

Managed by Martin Hudson and Jane Lennard, Mercantile aims for capital growth from a portfolio of medium-sized and smaller UK companies. It also aims to maintain long-term dividend growth at least in line with inflation. It is a £1 billion trust, so it is not aiming at tiny companies, but this is no closet index tracker, either; Martin and Jane will take strong positions and make big calls against the market if they feel it is right.

The trust has around 180 holdings, although 60 of those make up 85% of the portfolio. Some of the biggest holdings are household names such as Taylor Wimpey (LSE:TW), ITV (LSE: ITV), and William Hill (LSE: WMH). The trust is geared by around 5%, having moved from a net cash position. For income seekers it is a decent alternative to expensive trusts with “income” in their names—and of course you have decent growth prospects too.

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