Aberforth Split Level Income 27 May 2020

Aberforth Split Level Income Trust (ASIT) aims to generate a high yield from a value investment strategy in UK small caps and from gearing taken through zero-dividend preference shares (ZDPs). The trust has a fixed life and is to be wound up in 2024. All income is distributed to ordinary shareholders.

On a historical basis, following the coronavirus crash the yield is extremely high, at 8.5%. However, as we discuss in the Dividend section, investee companies are having to cut their payouts because of the current crisis. Although the trust has some reserves the board could employ, this means there is a chance of a cut this year or next. Nevertheless, thanks to the gearing as well as the investment approach, the income potential is still high relative to peers.

Recent portfolio activity has been limited, with the managers confident the majority of their holdings can generate superior returns despite the crisis. However, they have been tilting the portfolio towards companies which should be better placed to maintain or resume dividend payouts thanks to the strength of their balance sheets and the nature of their businesses.

On a total-return basis, ASIT has suffered in the COVID-19 sell-off owing to its value strategy, and because of structural gearing. However, this gearing means it could outperform considerably in any rebound. The portfolio is overweight UK earnings, meaning that it is particularly exposed to a recovery at home.

ASIT trades on a 13.6% discount to NAV, close to the sector average of 11.5%. However, the discount has been volatile relative to peers, perhaps thanks to the gearing.

ASIT could be an exciting, although potentially volatile, way to play a recovery in the UK. The high levels of gearing, overweight to UK earnings and extremely cheap portfolio offer the potential for high beta in any relief rally.

While the shape of the recovery is hard to forecast given the influence of medical and political matters, the managers tell us their base case is for a recovery to start towards the end of the year. We can see this being faster than expected if the medical data continues to improve and pressure from the backbenches grows when parliamentarians return to Westminster in June. However, there’s a chance of the government attempting to extend or reimpose lockdown restrictions.

Many will look to ASIT for yield first and foremost. In our view, a dividend cut is likely this year or next due to the fact that as a young trust, ASIT has only built up reserves of around 40% of last year’s final dividend. However, we would still expect the trust to offer a premium yield versus the equity income sector, thanks to the gearing and the low valuations on the market.

The fixed capital entitlement of the ZDPs reduces the potential capital growth for ordinary shareholders. However, as we discuss in the Gearing section, there is scope for highly attractive returns on quite conservative assumptions, and the fixed life means discount risk is eliminated for those who can hold to July 2024.