Faith Glasgow assesses whether investment trusts can continue increasing income payouts in the coming years.
Investment companies have long been an attractive proposition for income investors – retirees especially – who rely on a steady and dependable stream of cash being paid out from their portfolios to help fund their living expenses.
That’s because, unlike open-ended companies, investment trusts have the capacity to retain up to 15% of the dividends they receive each year from the companies in their portfolio. That enables them to build reserves on which they can draw in tough years when dividends are cut.
Last year was undoubtedly such an occasion, as the fallout from coronavirus crippled economies worldwide and forced swathes of businesses to reduce or cancel their dividend payouts. UK dividends were particularly hard hit, falling 44% according to the Link Group UK Dividend Monitor, while the Janus Henderson Global Dividend Index found that payouts were down by more than 12% worldwide.
“The importance of investment companies’ income advantage proved crucial in 2020,” explains Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC).
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The AIC calculates that two-thirds of the 116 equity-focused investment companies with revenue reserves and yields of more than 1% drew on those reserves to top up dividend shortfalls in 2020. As a result, 85% of equity income-paying investment trusts were able to increase or maintain their dividends to shareholders. In contrast, only 23% of open-ended funds managed to do so.
Revenue reserves certainly saved the reputation of most of the AIC’s dividend heroes - the elite band of trusts that have increased their dividend payout every years for more than 20 years. Almost every one made use of its reserves to some extent in 2020, although the amount drawn varied widely, reflecting both the size of the trust and the yield.
The use of revenue reserves meant that of the 21 trusts with a 20-year plus record of year-on-year dividend growth in March 2020, all but two – Temple Bar (LSE:TMPL) and British & American (LSE:BAF) – managed to grow their payouts over the year to March 2021, despite the economic turmoil caused by lockdown.
Two trusts merged with other trusts and therefore also left the list (Perpetual Income & Growth and Invesco Income Growth), while Aberdeen Standard Equity Income (LSE:ASEI) clocked up 20 years and joined it, bringing the number of dividend heroes up to 18.
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How the revenue reserve actually works
It is useful at this point to understand how a revenue reserve actually works. It is easy to get the impression that it is somehow ‘ring-fenced’ – a pot of cash sitting idle and unproductive, ready for rainy days down the line.
But that’s not the case. In reality, it amounts to little more than an accounting tactic - an entry in the books to show retained revenue. That money is part of the trust’s net asset value (NAV) and is invested in the same way as the rest of the portfolio. If some of it is needed to top up dividend distributions, then the manager has to sell holdings or dip into the cash element and the NAV is affected.
Clearly, while the system of revenue reserves is core to dividend sustainability, the important thing for income investors is to get a sense of how secure their dividend is likely to be in the event of a big economic shake-up like last year’s lockdown, which could have a longer-term impact on corporate payouts generally.
This is where dividend cover comes in. Conventionally, dividend cover shows the ratio of a trust’s net earnings – including the income received from its investee companies – to net dividends paid out.
As Andrew Rees, an analyst at broker Numis, explains: “In general, a sustainable dividend would be one that is fully covered by earnings (ie dividend cover of 1.0 times), although as we saw in 2020, there can be instances where short-term shocks to earnings mean that payment of an ‘uncovered’ dividend makes sense.” When trusts pay uncovered dividends, they are using revenue reserves to top them up to the required level.
The question then is whether, or how quickly, trusts' earnings will recover to their pre-pandemic levels. If many companies have used the crisis as an opportunity to rebase payouts permanently, it is likely to impair the dividend heroes’ ability to keep paying the same level of dividends sustainably, because they will have to keep dipping into reserves.
One useful measure for investors is the number of years of dividend at its current level that a trust’s revenue reserves will cover.
Somewhat confusingly for those not in the know, the AIC defines this as dividend cover. To try and avoid confusion, I have changed the table below to refer to ‘reserve cover’.
As the table shows, 10 of the dividend heroes have the equivalent of more than a year’s worth of dividends in their reserves. So even if they received no payouts at all from investee companies this year, they would still be in a position to maintain or grow their distributions to shareholders.
Drilling down into the dividend heroes
|Investment company||AIC sector||Dividend yield (%)||Number of consecutive years dividend increased||Reserve cover (yrs) at 30 April 2021**||Revenue reserves (base currency) at 30 April 2021|
|City of London (LSE:CTY)||UK Equity Income||4.8||54||0.54||45,623,000|
|Alliance Trust (LSE:ATST)||Global||1.5||54||2.18||99,174,000|
|Caledonia Investments (LSE:CLDN)||Flexible Investment||2||53||7.58*||255,500,000*|
|BMO Global Smaller Companies (LSE:BGSC)||Global Smaller Companies||1.1||50||1.83||17,923,000|
|F&C Investment Trust (LSE:FCIT)||Global||1.4||50||1.56||100,930,000|
|JPMorgan Claverhouse (LSE:JCH)||UK Equity Income||4.2||48||1.20||21,667,000|
|Murray Income (LSE:MUT)||UK Equity Income||3.9||47||0.55||22,195,000|
|Scottish American (LSE:SAIN)||Global Equity Income||2.5||47||0.81||16,406,000|
|Merchants (LSE:MRCH)||UK Equity Income||5.2||39||0.66||22,102,171|
|Scottish Mortgage (LSE:SMT)||Global||0.3||38||0.49||22,865,000|
|Scottish Investment Trust (LSE:SCIN)||Global||2.9||37||2.87||44,334,000|
|Value and Indexed Property Income (LSE:VIP)***||UK Equity Income||5.8||33||0.61||3,191,000|
|BMO Capital & Income (LSE:BCI)||UK Equity Income||3.7||27||0.94||11,849,000|
|Schroder Income Growth (LSE:SCF)||UK Equity Income||4.1||25||1.31||11,470,000|
|Aberdeen Standard Equity Income (LSE:ASEI)||UK Equity Income||5.5||20||0.87||8,748,000|
Notes: *Caledonia’s data is retained earnings rather than revenue reserves, but the board has committed to using this to support the dividend. ** The AIC refers to this measure as dividend cover. *** Value and Indexed Property Income has changed its strategy to focus on direct UK property investments and therefore no longer strictly counts as an equity trust.
Source: AIC/Morningstar as 14 May 2021.
However, Rees makes the point that just because a trust's revenue reserves are currently equivalent to less than the cost of one year's dividend payment, this does not mean that the trust will not be able to maintain its dividend, because revenue reserves are only drawn on to the extent that the dividend is not covered by earnings.
For instance, he says: “If City of London's earnings per share for the current financial year are equal to its dividend per share, then the reserves will remain unchanged.
“The issue in 2020 was that widespread dividend cuts and suspensions from UK corporates meant that equity investment trusts' earnings decreased substantially, meaning their dividends were (for the most part) not covered by earnings and therefore drew upon revenue reserves.”
Many UK companies have since reinstated their dividends, so the indications are that 2021 will not be as bad a year for investment trusts' earnings, but the fact is that an important factor in the ability of the dividend heroes to sustain and grow their dividends in coming years will be the extent to which earnings recover, and not just the extent of their revenue reserves.
If the wider dividend landscape remains fragile in 2021 and beyond, investment trusts - including the dividend heroes – may again face shortfalls from their investee companies and need to draw on revenue reserves.
A recent note from investment trust analyst Stifel highlights the fact that this is a very real risk. It warns of “the likelihood that dividends paid by investee companies to listed funds will take time to recover” after the damage done to businesses in 2020.
The note makes the point that despite the new-found significance of dividend cover as a metric for investors, many boards are failing to mention it or provide figures in their accounts for 2020.
“In the past, dividend cover wasn’t such a concern for investors, given most trusts were paying dividends fully covered by revenues,” Stifel comments. “However, this has now changed dramatically, with many equity trusts seeing declines of 15% to 45% in their revenue earnings in the past year.”
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Stifel is keen to see investment trust boards talking much more about dividend cover as one of the key measures. However, it also recommends they should also provide investors with more general insights into what’s happening with dividend payments from the different companies in their portfolio.
That might include differentiating between dividends that have been temporarily suspended (and where normal service is likely to be resumed shortly) and those that have been rebased or cut and will likely have a more prolonged impact on the trust’s income prospects. It could also usefully include a dividend forecast from the manager for the coming year.
Clearly, if you’re investing for income, it’s well worth checking the capacity of any trust you’re interested in to cover current distributions from earnings. You may also want to favour those with reserves sufficient to cover at least a year of payouts. Information on the latter measurement can be found (as ‘dividend cover’) on the AIC website’s individual company profile pages.
More generally, though, if dividends don’t bounce back to pre-pandemic levels, the dividend hero boards may face some difficult questions about the sustainability of dividends and their willingness to make ongoing distributions from reserves or capital in order to preserve that record of dividend growth.
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