As I write this in October 2016, stock markets are at record highs and the very best businesses are trading at high valuation multiples. The FTSE 100 has crossed the psychological 7000 levels and is trading at a P/E of above 20 and a dividend yield of 4%. This is in stark contrast to the beginning of the year when it was trading at 5800 and the market was yielding 4.9%. For investors that sunk m money into the markets during the lows of Jan/Feb of this year, it has turned out tone an excellent deal as they were able to buy many stocks at a discount of 10% – 15% as compared to todays levels. But if you missed the boat and didn’t buy during the lows earlier this year, the good news is that you can still buy stakes in the best companies at a close to 10% discount. Enter investment trusts.
What are Investments Trusts?
An investment trust is a publicly traded company that holds a portfolio of diversified assets. The portfolio can consist of equities (stocks), bonds, real estate, commodities or other asset classes depending on the investment manual.
What makes an investment trust special is that the share price of the trust could trade at a different price to that of its underlying holdings.
For example:If a trust has £100 in assets and has 5 shares for instance, each share should trade at £20. (£20 * 5 shares = £100). But this is not always the case. Investment trusts usually trade at a premium or discount.
- Premium – When the share price of the trust is greater than the underlying assets held the trust. Using the above example, if the shares traded at £25 instead of £20, it would trade at a premium of 25%.
- Discount – When the share price of the trust is less than the underlying assets held the trust. Using the above example, if the shares traded at £15 instead of £20, it would trade at a discount of 25%.
As you can see, when investment trusts trade at a discount, you can buy the underlying assets of the trust at a lower level than if you were to buy them outright on the stock market.
Merchants Trust + Dunedin Income Growth Investment Trust
Many investment trusts have had their discounts widen over the past year. Among them are two trusts, Merchants and Dunedin. A widening discount may mean that the market is taking a dislike to a trust. This can be due to levels of gearing, the portfolio manager, the underlying investments held by the trust, or a whole host of other reasons. But it could also signal that the market is being irrational thus providing individual investors with a great opportunity to buy into the trust.
With Merchants and Dunedin, I think it is the latter. Both have excellent track records as seen by their exceptional dividend paying records. Merchants has increased its dividend for the past 34 years and Dunedin has done so over the past 16 years. This is an excellent track record and both trust have enough dividend cover and cash balances to continue paying increased dividends over the forceable future.
Investment Trust Vs Index Funds
Many investment trust have the same or very similar top 10 holding to a plain vanilla low cost FTSE 100 index funds. With the costs of an investment trust (management fees etc) being just over 1% and a low cost index fund being close to 0.1%, many will ask if it is worth paying the extra fee.
For me, the answer is yes. These are some of the reasons:
- Discounts – If you buy into an index fund, you buy at the market price. With investment trusts, you can buy the underlying assets at a discount.
- Gearing – Investment trusts can use gearing (borrowings) to juice up returns.
- Better companies – An index fund is forced to hold certain companies. For example, the FTSE 100 has to hold the top 100 London listed companies. So its required to hold poor returning companies like airliners which I would not hold in a million years. Investment trusts can cherry pick the best companies thus giving you higher returns over time. In this respect, Merchants and Dunedin have ownership stakes in excellent cash generative businesses like Unilever, British American Tobacco, GSK and Nestle.
I bought my stakes in both trusts two weeks ago. I bought 192 shares in Merchants at a share price of £4.25. I bought 331 shares in Dunedin at a share price of £2.46.
In total, both these purchases cost me £1659. For this, I am expecting to get £84 in dividend income per year thus giving me a handsome yield of 5.06% on purchase. The great thing about buying into companies or trusts with a fantastic dividend track records is that the amounts I receive every year will keep increasing without me having to do anything. I will receive £84 in the first year but even taking a conservative estimate, I expect to receive £87 in 2018, £90 in 2019 , £93 in 2020 and so on. This is the beauty about dividend growth investing over the long-term,
As I mentioned in a previous post, I recently crossed the £1000 mark in dividend income and thus the dividends from these two trust will add to that and take me one step further to my goal of financial freedom.