Small cap income stocks perfect for your ISA
Richard Gill, CFA, reviews three companies he thinks could contribute significantly to both your ISA dividend income and capital growth over the next few years.
The UK economy is in trouble. According to the Office for National Statistics, in December last year the government borrowed £34.1 billion, up from just £5.9 billion in the same month in 2019. This was the highest amount borrowed in the month of December on record and came as the Treasury continued to respond to the coronavirus pandemic, along with a steep drop in tax receipts. That took the government’s budget deficit to £271 billion for the first nine months of the financial year and saw the country’s total net debt rise to an unprecedented £2.1 trillion – over two million million pounds!
With the pandemic far from over it’s highly likely this figure is only going to rise in the coming months as the government borrows more to shore up the flagging economy. And in the long run someone is going to have to pay for it. That someone is you and me. So with inevitable tax rises looming on the horizon it’s as important as ever to shield your investment returns away from the tax man.
Many people turn to ISAs when looking to minimise their tax bill. However, interest rates on even the highest earning, essentially risk-free, Cash ISAs remain stubbornly low. According to financial website Moneyfacts the average easy access Cash ISA was paying just 0.25% in January this year. That means for every £1,000 you’re earning interest of £2.50 a year, not even enough to buy a pint of beer when the pubs open again!
Fortunately, the Stocks & Shares ISA provides a range of opportunities for UK taxpayers to earn higher, tax-free returns on a range of assets including shares, investment funds and corporate & government bonds. Since 2013, shares in AIM listed companies have been eligible for inclusion in an ISA, opening up a whole new range of shares for investors. The annual allowance is a generous £20,000 (which expires on 5th April) and you won’t pay any tax on dividends or capital gains on assets held within the tax-free wrapper.
Here follows three companies I think could contribute significantly to both your ISA dividend income and capital growth over the next few years.
SECURE INCOME REIT
Property investment companies have clear risks associated with them at present, seeing a perfect storm of falling asset values, struggling tenants and forced rent deferrals and concessions. So it’s unsurprising that the sector is currently unloved, with many property shares trading at a substantial discount to their stated net asset values. But for brave investors, that provides opportunities to take advantage of an economic recovery in the long term.
I believe one of the most solid property investors is Secure Income REIT (LON:SIR), a business founded in 2014 by well-known property guru Nick Leslau and his team. Its aim was to generate long-term, inflation protected, secure income from real estate investments. The strategy was designed to satisfy investors’ growing demand for high quality, safe, inflation protected income flows – perfect in the current environment.
The portfolio, as at 30th June last year, consisted of 161 properties valued at almost £2 billion. Before certain concessions (see more below) the portfolio generated passing annual rent of £111.8 million. Major assets include well known theme parks Alton Towers and Thorpe Park, let to entertainment operator Merlin Entertainments, along with 123 Travelodge budget hotels. Manchester Arena, conference venue the Brewery in the City of London, 18 pubs and 11 private hospitals make up the majority of the rest of the portfolio. Providing long-term visibility and stability, the company’s 20.8-year Weighted Average Unexpired Lease Term is one of the longest in the UK public real estate sector.
Rollercoaster year
Unsurprisingly, many of the company’s tenants struggled in 2020 due to the pandemic related restrictions. As a result, rent concessions were agreed with certain clients. Of the major tenants, Merlin Entertainments had two quarterly rents worth £17.8 million deferred for collection in September 2021, with rental cash flows returning to their previously contracted levels as at December 2020. More significantly, Travelodge entered into a CVA in June and £14.4 million of rent was foregone for 2020 and £8.6 million for 2021. Rents are due to return to the originally contracted levels from 1st January 2022.
Numbers for the six months to June 2020 reflected these troubles, with net rental income falling from £67.6 million to £59 million. Encouragingly, healthcare rents (which make up 34% of passing rents before concessions) continued to be received on time, in full, with no concessions. However, the portfolio valuation was down by 6% to £1.96 billion over the period, with 79% of the net decline coming as a result of a fall in the value of the budget hotels, down 20.3%. Secure Income retained a strong balance sheet at the period end with the loan to value (LTV) being just 35.3% (low for a property investor), with uncommitted cash amounting to almost £220 million.
More recently, the company reported in early January that 98.6% of the £21.6 million of rent that fell due between 25th December 2020 and 7th January 2021 has been collected. This included rents received for the quarter commencing 25th December 2020 from Merlin following the end of their six month rent deferral period.
Yes SIR!
Shares in Secure Income REIT have fallen from a peak of 473p pre-pandemic to a current level of 306.5p. That values the business at a shade under £1 billion. Compared to the last stated NAV per share figure of 383.9p as at the end of June the current discount is a substantial 20%.
The current threats are clear, with the reduced rents not expected to end until December this year, along with the potential for further concessions and reductions in the value of the portfolio. So this is clearly a recovery play, but also with some defensive characteristics.
In July last year the company updated its dividend guidance. While the level of support extended to tenants means that maintenance of the core dividend forces partial funding from cash reserves, the maintenance of payments is considered appropriate by the company in the current circumstances. Three quarterly payments of 3.65p have been made since then, which implies an annual yield of 4.76%. Once the originally contracted rents return I see scope for an increase in the payments.
It’s worth flagging the exceptional management team here. Nick Leslau et al had success at Max Property Group, the AIM listed firm which was sold for £448 million in 2014 after being set up and raising £220 million in 2009. Management also have a significant 12.4% stake in the business, recently showing their confidence by buying £5.2 million worth of shares from a retiring non-exec. For income and long-term recovery Secure Income REIT is a buy and hold.
CARETECH
I fist covered this next company back in March 2016 when the shares were trading at 235p. Following the acquisition of a major rival and consistent revenue growth since then they currently trade 123% higher at 524p.
Founded in 1993 and listing on AIM in 2005 is CareTech (LON:CTH), a provider of specialist social care services. Operating through the Foster Care, Children’s Services and Adults Services divisions it supports around 5,000 adults and children with a wide range of complex needs in more than 550 day services. These are provided to end customers via a portfolio of over 200 properties located throughout the country, with CareTech being paid for its work by local authorities and health service commissioners.
The business was significantly expanded in October 2019 following the acquisition of fellow London listed company Cambian Group, a children’s specialist education and behavioural health service provider. The business was bought for £372 million in a mixture of cash and shares, with CareTech taking on new banking facilities of £334 million to help finance the deal.
Healthy Growth
The year to September 2020 was another good one for CareTech, with results ahead of expectations as all its operations remained open despite the pandemic challenges. At the top line, revenues grew by 8.9% to a record £430 million, with underlying earnings up by 14.4% at 43p. Highlights of the period saw Cambian performing slightly ahead of targets set out at the time of acquisition, 18% operating profit growth in the Children’s Services division and ratings from the Care Quality Commission and Ofsted of 91% and 82% respectively in the “Good” or “Outstanding” categories.
The net cash flow from operations for the year was very strong at £84.4 million, which helped reduce net debt by £22.2 million to £268.9 million. Management believe that they will achieve their target of reducing the net debt/EBITDA ratio to below 3 times in the current financial year.
Growing further by acquisition, following the period end CareTech added a fourth division to its offerings by buying Smartbox Assistive Technology for an initial £7 million. Smartbox is a creator of software and hardware that helps disabled people without speech to have a voice and live more independently, with products including communication aids, environmental control devices and computer control technology. The business made revenue of over £10 million in 2019, has a track record of profitability and is expected to be earnings enhancing in the first financial year of consolidation.
Value, Growth and Income
Despite growth seen over the years it looks like there’s still a lot more for CareTech to go for. Even accounting for the Cambian acquisition, the group still only has a small share of what is a fragmented market for social care in the UK, estimated by the company to be worth c.£12.6 billion per annum and growing at around c.3% a year. Growth is now being sought oversees too. Last year the company made its first international investment, taking a 52% stake in AS Investment Holdings, the largest provider of outpatient mental health services in the UAE. This is a region which the company believes represents an attractive market with underserved requirements for specialist social care expertise.
CareTech shares currently trade on a historic price earnings multiple of just over 12 times. I believe this looks attractive given the firm’s track record and that in the results management commented, “We expect to continue double digit EPS growth…” To help deliver this, senior management have recently been incentivised with a share award plan which vests in full only if earnings grow by 35% over the next three years. What’s more, the dividend has increased every year since 2007, up 325% in total, with last year’s 12.75p payment equating to a modest yield of 2.4%.
HSBC recently initiated coverage on the shares with a target price of 685p, which implies 31% upside from current levels. Buy and hold.
POLAR CAPITAL HOLDINGS
As interest rates remain at record lows and investors continue to seek returns worth getting out of bed for, a number of money management firms have been performing well. One such firm is Polar Capital Holdings (LON:POLR), a boutique, active fund manager with a strong focus on the technology sector. The company recently posted a cracking set of results for the six months to September 2020, a period which saw the worst of the lockdown related restrictions in the UK.
Over the six-month period total assets under management grew by an impressive £4.2 billion to £16.4 billion; however, that was from a lower base in March due to the market sell-off at the time. Of the increase, £907 million came from net client inflows with £3.6 billion coming from fund performance. That helped pre-tax profits rise by 8.4% to £27 million, the figure also boosted by gains on seed investments.
Tech darlings
Like most fund managers, Polar Capital earns the majority of its income from management and performance fees on a range of funds. The largest is the £6.3 billion, almost 20-year-old, Global Technology Fund, somewhat shrewdly launched in 2001 just after the dotcom bubble burst. Up to the end of 2020 it had returned a highly impressive 902%, well ahead of its benchmark, and benefited from last year’s US tech boom. Elsewhere are the popular £1.6 billion Healthcare Opportunities Fund and £1.2 billion UK Value Opportunities Fund.
Since listing on AIM in February 2007, Polar Capital has grown strongly, albeit seeing the usual swing in profits associated with stock market cycles. Revenues grew from £41.3 million in 2007 to £177.5 million in FY2019, with net profits up from £23.7 million to £52.4 million. Substantial dividends have also been paid along the way, with the shares up from 190p at IPO to a current 648p.
Since the half year end in September trading has continued to be positive. In its results Polar confirmed that the pipeline for the remainder of the financial year was encouraging, with net inflows of £158 million seen in October. A further update in January confirmed that asset inflows continued over the following two months and by the end of December total assets under management had risen to £18.9 billion.
Of the £6.7 billion rise since March, £5.2 billion came from market movements and fund performance, with 81% of AuM performing ahead of benchmark over the calendar year. That helped net performance fee profit for the nine months to December grow to £19.3 million, up from £8.8 million in the comparable period in 2019. Finally, the net inflow momentum of the last quarter is said to have continued into the first two weeks of January.
Polar Bull
The current financial year looks likely to be a good one for Polar Capital, especially given the increased performance fees mentioned above. Acquisitive growth is also on the cards, with December last year seeing the £15.6 million purchase of UK based boutique asset manager Dalton Strategic, which added £1.24 billion of assets under management.
Also, last October the company’s international focus was expanded via the acquisition of the International Value and World Value team from Los Angeles asset manager First Pacific Advisors. A new joint venture, Phaeacian Partners, has been established, which contains two funds worth $545 million at the time of the deal. This should help Polar further diversify its offerings and reduce exposure to its flagship technology fund should US tech stocks lose their shine.
The company is in a strong financial position, with net cash of £82.5 million as at the September period end – equal to 13% of the current market cap. That helps to support the dividend policy, which looks to pay out a range of 55% to 85% of adjusted full-year earnings. The interim payment has already been increased from 8p to 9p per share so I think that last year’s total payment of 33p should at least be maintained. That equates to an attractive 5.1% yield.
Overall, bearing in mind that the company’s earnings will likely swing along with the stock market, Polar Capital seems like a solid business with an excellent long-term record. The dividend looks safe and likely to grow, with the company’s expansion plans looking sensible and focussed. Buy and hold.
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