Questor: This trust proves there’s more to income than just yield

Income portfolio: Mercantile’s dividend growth potential more than makes up for its modest yield

The Mercantile Investment Trust may appear an unusual choice for an income portfolio at first glance.
Investors may naturally conclude that its 3.2pc dividend yield is simply too low for it to merit a place in any income portfolio – especially at a time when the FTSE All-Share index’s yield stands at 3.7pc.
Moreover, the trust’s aim is not squarely focused on income-seeking investors. Certainly, it seeks to grow dividends by at least as much as inflation.
But its focus on small and mid-cap UK stocks, which typically offer less stability than their larger peers, when aiming to generate long-term capital growth means many income investors may choose to overlook it.
Questor, though, strongly feels there is much more to income investing than a high yield and low volatility. Dividend growth, in this column’s view, is a grossly underappreciated piece of the income investing puzzle.
Without a sufficient amount of it, even the most attractive yield will gradually become less enticing. Over the long run, this can lead to a severe decline in an investor’s purchasing power.
Crucially, Mercantile has an excellent track record of inflation-beating dividend growth. Over the past decade, for example, its dividends have risen by 91pc, which  equates to a growth rate of 6.7pc per annum. Inflation has totalled 33pc, or 2.9pc per annum, over the same period. Investors in the company have therefore enjoyed a significant rise in their purchasing power.
The trust’s focus on UK-listed mid and small-cap stocks is set to drive future dividend growth. Although the UK economy has struggled over recent years, with it experiencing a recession in the second half of last year, it now faces a period of modest inflation and interest rate cuts that should create stronger operating conditions for domestically-focused firms. 
Furthermore, a substantial proportion of small and medium-sized companies that are listed in the UK have exposure to international markets. Around 55pc of revenues generated by FTSE 250 index members, for example, are from abroad.
Given that an unwinding of restrictive monetary policy is also due to take place in the Eurozone and the US, the prospects for mid and small-cap firms, which are grossly undervalued on a relative basis, are extremely bright. This should allow them to generate growing profits and pay higher dividends. 
An improving economic outlook is also set to catalyse the trust’s capital returns. Its share price gains should be bolstered by a relatively high gearing ratio of around 15pc. 
Although this will mean elevated share price volatility in the short run, a magnification of returns is likely to prove positive in a rising market. And with the trust currently trading at a 8pc discount to net asset value, it offers excellent value for money.
The company’s track record of performance, meanwhile, is relatively sound. Its 8pc annualised share price rise over the past decade is 2.9 percentage points greater than that of the FTSE All-Share index, which serves as the trust’s benchmark.
And since first being tipped by Questor in June last year, albeit without being added to our income portfolio at the time, the company has produced a capital gain of 17pc. 
The trust’s major holdings include well-known firms such as Bellway, Dunelm and Cranswick that have previously been tipped by Questor. Its overweight positions in the consumer discretionary and industrials sectors mean it is well placed to capitalise on an improving outlook for cyclical firms as the economy’s growth rate increases.
Mercantile’s addition to our income portfolio will be funded by the sale of Real Estate Credit Investments. The company, which invests in commercial and residential property debt, was purchased in two tranches.
The first was in May 2020, which has produced a 4pc gain. The second tranche was bought in January 2022 and has generated a 19pc capital loss. The sale aligns with our overarching aim to refocus the income portfolio on equities.
Certainly, Mercantile’s dividend yield is relatively low for an income holding. But its track record of dividend growth, and the potential for further increases as the economic outlook improves, means that it merits a place in our portfolio.
When combined with its strong track record of benchmark outperformance, low valuation and relatively high gearing, its risk/reward opportunity is favourable on a long-term view.
Questor says: buyTicker: MRCShare price at close: 241.5p
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