Targeting reliable income through consistent dividends: A glimpse at The Merchants Trust

Dividends are a regular distribution to shareholders, normally paid every six months out of a company’s earnings. Companies are not required to pay dividends and some do not. That is particularly true of fast-growing early-stage businesses that are reinvesting heavily in their operations.

Companies that do pay dividends tend to be established businesses in areas such as banking, the utilities and commodities, which benefit from reliable income streams. Dividends provide a means of incentivising shareholders to continue holding their shares and also attract prospective buyers of the stock.

Dividends are important to investors because they can help provide financial security. The dividends paid by these established businesses can sometimes provide a reliable and growing income, whereas the price of their shares may well prove much more volatile and can be affected by factors that have nothing to do with the fortunes of the underlying business, such as general stock-market turbulence. Some businesses pay dividends year-in, year-out, but their share price does not necessarily rise every year.

In addition, investors can reinvest their dividend income in more of the same stock or bond, and thus benefit from the power of compounding, which enables wealth to steadily increase, helping investors achieve their financial goals.

The importance of dividends and the power of compounding for investors in UK stocks, which The Merchants Trust focuses on, is clear from history. According to Barclays’ 2023 Equity Gilt Study, £100 invested in UK shares in 1945 would have grown to £215 by March 2024, after adjusting for inflation – equivalent to an annual gain of just 1 per cent in real terms, over almost eight decades. However, an investor who continually reinvested the income generated by those same shares would have seen their wealth grow to £5636 – again, after inflation. That equates to an average annual return, in real terms, of 5.4 per cent.¹

Dividend growth is central to the strategy of The Merchants Trust plc. The Trust aims to provide its investors with an efficient, competitive and cost-effective way to achieve an above-average level of income and income growth, together with long-term capital growth through a policy of investing mainly in higher-yielding large UK companies.

The Merchants Trust focuses on targeting companies that are well established but that are undervalued stocks . An undervalued stock is one that is selling at a price below its intrinsic value, often due to market overreactions, temporary setbacks or being overlooked by investors, presenting a potential investment opportunity as the price may correct over time.

The Trust's income investing bias is supported by historical evidence that shows portfolios yielding high dividends can generate above-average total returns in the long term.

However, the dividend yield alone is never a sufficient reason for buying a share. We only buy companies where we believe shareholders can make an attractive total return. The buy and sell decisions are both driven by total-return considerations. Furthermore, we do not have a rigid policy to sell shares at a particular yield.

Our research focuses particularly on the analysis of sustainable company cash flows, which underpin a business’s ability to pay dividends, and typically provide the truest measure of corporate performance.

In common with other dividend income trusts, The Merchants Trust can add money to its reserves when times are good and draw on those reserves when market conditions are less favourable. That was the case in 2021 and 2022, during the pandemic, when the Trust drew on its reserves to keep growing the dividend paid to shareholders. That cycle works very well over time, and the Trust is now once again in a situation where the dividend is covered by earnings and is able to add to the reserves once again.

¹ https://www.investorschronicle.co.uk/content/f33af1ba-6bcd-5b93-8af3-ab27524627c6