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27/12/20183 mins

A contrarian approach can pay dividends

As contrarian investors, we prefer to plot our own course rather than follow the herd. We often speak about our quest to find ‘ugly ducklings’, companies that are shunned by others but offer a real prospect of improvement. And while the obvious upside to this approach is the potential for share price appreciation, it can also offer another valuable source of returns as unfashionable companies often have higher than average dividend yields.

Seeing the value in ugly ducklings

It goes without saying that the ‘ugly ducklings’ we choose are unloved, but we believe that they have the potential to improve their businesses. The ability to adapt and thrive over the longer term often comes down to how much flexibility or control the company has to make needed change. A sustainable dividend from such companies is attractive to us as it offers a return while we wait for our thesis to unfold.

Of course, not every investment in our portfolio pays dividends and we wouldn’t necessarily overlook a prospective investment for that reason. A company navigating the low point in its cycle might opt to forgo a dividend to reinvigorate its business. This prudent approach can hasten the company’s recovery and potentially allow more sustainable dividend payments to recommence. Indeed, a dividend reinstatement can be an important signal that the company’s rehabilitation is gaining traction.

This scenario is currently playing out at Tesco, one of our biggest holdings. Tesco cut its dividend after a difficult period, during which profits fell and discounting rivals gained market share. Since then, the company has regained its footing, allowing management to reintroduce the dividend.

As long-term investors, we have time on our side as we wait for a nascent recovery to become established. Patience is key to contrarian investing. A certain fortitude is also required to withstand the anxiety and negativity of the market, while holding steadfastly to our convictions. But the potential pay-off can be more than worth the wait.

From sour grapes to an exceptional vintage

A great example is Treasury Wine Estates, formerly the biggest holding in our portfolio. We invested in this company in August 2015, when it was very much out of favour. The catalyst for change was a new management team, whose strategy transformed the business from an ‘ugly duckling’ to an elegant swan before, we decided to sell our stake (or, to continue with the metaphor, it flew our nest) leaving a £39 million profit – almost three times our original investment. Not all of our investments are fruitful but examples such as this demonstrate the potential pay-off from being patient.

Retail – down, but not out

Another example is the retail sector. The popular view is that the high street is on its last legs with several prominent names succumbing to difficult trading conditions in recent months. By contrast, some online retailers such as Amazon are hugely in favour (though perhaps less so lately with the British Chancellor).

For some time, we’ve been sifting through prospective investments in the retail sector that meet our unloved criteria. Two such companies currently are Marks & Spencer and Macy’s, where we believe signs of improvement are starting to appear. Macy’s has delivered sales that were surprisingly strong and has shown a more disciplined approach to discounting. Meanwhile, Marks & Spencer has been revitalising its product lines and overhauling its pricing strategy. Both have the potential to be strongly cash generative which provides their management teams with a wider range of strategic options.

Enduring growth

Paying dividends to our own shareholders has also been part of our 131 year heritage. We’ve recently increased the frequency of our dividend payment to quarterly, aligning more with the desires of the majority of our shareholders. One of our aims is to grow the dividend ahead of UK inflation and this is supported by a record of raising or maintaining our regular dividend at least each year since the Second World War.

 

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.

The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.

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