Cash is not king. During a market rout, seek undervalued income
Questor is The Telegraph's stock-picking column, helping you decode the markets and offering insights on where to invest.
Extreme stock market volatility will inevitably prompt some income investors to declare that 'cash is king'. After all, cash does not fluctuate in value and currently offers an income return in excess of 4pc.
However, holding cash for the long term is problematic for several reasons. It offers no capital growth potential, which means it has a rather drab long-term track record versus shares, and is likely to produce a diminishing income return as monetary policy easing continues.
By contrast, share prices are extremely likely to rise from their current levels and produce growing dividends as the economic outlook gradually improves.
Therefore, rather than sitting on piles of cash in perpetuity, Questor believes that drip-feeding excess cash into undervalued shares is a far better idea. With several high-quality income shares now offering lower valuations and higher yields than they did earlier this year, there is a wide range of attractive options for income-seeking investors.
For example, FTSE 250-listed The Merchants Trust has a dividend yield of 5.5pc thanks to its 5pc share price decline since the start of the year. This is 190 basis points higher than the FTSE All-Share index's yield, and the trust has the added bonus of raising its dividend for the past 43 consecutive years, a record it won't be keen to lose.
While this does not guarantee further dividend growth in future, when combined with revenue reserves amounting to around 65pc of last year's shareholder payout, it suggests the trust could prove to be a relatively reliable income option.
In addition, its dividends have risen at an annualised rate of 6.3pc since 1982. This compares favourably with an average annual inflation rate of around 3pc over the same period and, as a result, its shareholders have enjoyed a material increase in their purchasing power.
The company's recent share price decline also means that it now trades at a 2.3pc discount to net asset value. This compares with an average discount of just 0.2pc over the past five years and suggests the trust offers good value for money.
Separately, the company's major holdings are dominated by well-known FTSE 100 stocks including British American Tobacco, GSK and Shell. However, it also has significant exposure to mid-cap shares, with 32pc of its assets currently invested in the more domestically-focused FTSE 250 index.
This is significantly higher than the mid-cap index's representation in the FTSE All-Share, which sits at roughly 15pc of the wide-ranging market, meaning the trust's performance is more closely aligned with the UK economy's performance vis-à-vis its benchmark.
In Questor's view, this adds to Merchants' overall appeal. The FTSE 250 has, after all, been exceptionally unpopular with investors over recent years. As a result, depressed valuations were widespread even before the stock market's recent bout of extreme volatility. Over the long run, today's grossly undervalued stocks could deliver strong total returns as the economy's performance gradually improves.
Of course, a significant mid-cap focus and a gearing ratio of just over 14pc mean the company's share price is likely to be relatively volatile. It could even fall further in the short run as the ongoing global trade war may yet worsen before it improves.
We must also note that the company's shares have lagged the FTSE 100 index by 10 percentage points since our 'buy' recommendation in February 2020.
In this column's view, however, Merchants has a sound long-term outlook. Its relatively appealing valuation, significant exposure to the grossly undervalued FTSE 250 index and substantial gearing mean it is well placed to deliver capital growth as the economy's outlook improves.
When considered from an income perspective, the company's generous yield and longstanding track record of inflation-beating dividend growth equate to a worthwhile long-term opportunity.
The company therefore becomes the latest addition to our income portfolio. We will use excess cash generated from previous sales to fund its notional purchase.
Clearly, some investors will naturally be tempted to do the opposite and hold cash during the current period of economic and stock market turbulence. However, this column firmly believes that gradual purchases of high-quality, undervalued dividend stocks represents a far superior means to obtain an attractive income over the coming years.
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