abrdn Equity Income 01 February 2023

abrdn Equity Income Trust (LON:AEI) has a target of generating above-average income while also providing real growth in capital and income. In aiming to achieve these, the manager, Thomas Moore, has over the years taken a relatively unique approach amongst the UK Equity Income peer group. He’s a contrarian and with a view that systematically unloved stocks with resilient business models and strong cash flows will come good, he aims to take advantage by buying them cheap. As we show in the Portfolio section, across several measures, AEI’s portfolio trades at lower valuations than the benchmark index, the FTSE All-Share Index. However, what makes it stand out is its larger exposure relative to the benchmark across the mid and small-cap stocks, with only around half of the portfolio in the large FTSE 100 Index stocks.

While there is a bias towards the lower end of the market cap spectrum where there are strong growth opportunities, this has not compromised the portfolio’s income-generation ability as Thomas targets stocks that are also resilient to inflation, as well as those whose income-generation capabilities are not fully recognised by the market. With a prospective dividend yield of 6.5%, this is one of the highest in the peer group and easily better than the benchmark. Its strong revenue reserves have enabled the board to raise the dividend for 22 consecutive years, placing AEI in the AIC’s ‘Dividend Heroes’ list (see Dividend section).

AEI’s discount in recent weeks has narrowed significantly to just below par, which we believe is down to the encouraging forward guidance that the board have given on dividend prospects.

AEI’s value-positioning and the market’s preference towards growth stocks have not been helpful to performance over a five-year period. However, its performance during 2022 was better than the AIC UK Equity Income peer group, despite poor sentiment towards small and medium-cap stocks with the fears of a looming recession. Going forward, we believe the highly uncertain outlook for the UK and global economies should continue to be relatively beneficial for AEI’s overall value stance and its dividend payouts should be resilient, given the strong cash generation capabilities of the underlying portfolio companies and revenue reserves. Meanwhile, a reversal in sentiment towards mid and small caps could act as a boost to performance.

After the pandemic hit dividend payouts across the market, the key priority that the board tasked Thomas with was to generate sufficient income to cover the dividend. Thomas welcomed this challenge as it was consistent with his investment process that favours companies with strong cash flows and dividend potential that are not priced in. He successfully restored the portfolio’s dividend cover over the 2022 financial year. Revenue reserves are, once again, at strong levels, allowing the board to confidently give forward guidance for 2023 dividends of at least 22.8p per share.

In our view, AEI’s proposition should appeal to investors looking for a high-income yield that is well-protected against inflation, while also offering long-term capital growth potential.