City of London: the ‘ultimate backstop’ to keep paying a rising income

City of London (LSE:CTY) Investment Trust has a remarkable dividend track record, having raised payouts every year since 1966. In an interview with interactive investor’s collectives editor Kyle Caldwell, fund manager Job Curtis explains why its dividend is built on solid foundations.

Curtis also makes the case for equity income at a time when income-seekers can find high income from lower-risk assets, such as bonds and money market funds. He also explains why dividends investors are being “paid to wait” while sentiment towards UK equities remains low. City of London is one of interactive investor’s Super 60 investment ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today, I'm joined by Job Curtis, fund manager of the City of London Investment trust. Job, great to see you again.

Job Curtis, fund manager of the City of London: It's a pleasure.

Kyle Caldwell: So, Job, as you mentioned in a recent note to investors that UK companies are attracting attention from potential overseas buyers, including private equity firms. However, retail investors are continuing to shy away from the UK stock market. Why are they shying away and what needs to happen for that to change?

Job Curtis: Well, everybody's gone very global, [including] UK investors, and obviously, if you invest in, say, the American market, you've got the leading technology companies, which you just can't find the equivalent [for] in the UK. So, I can understand why people do want to have a lot of global exposure in their portfolios. But there is a lot of value in the UK, in my opinion. Certainly, even stripping out the fact that we don't have the big technology companies, we've got one or two, but nothing like…Microsoft Corp (NASDAQ:MSFT), Apple Inc (NASDAQ:AAPL), etc.

If you look at our companies on a like-for-like basis compared with some companies in other stock markets, there's a big valuation discount. Some people measure it [at] as much as 20%, and it can be higher in certain cases. If you look at oil companies like Shell (LSE:SHEL) versus US oil company Exxon Mobil Corp (NYSE:XOM), it's more than 20% valuation discount

We've got a pretty open system for corporate control and so there’s been a lot of takeovers. On City of London, Brewin Dolphin, the wealth manager was taken over by Royal Bank of Canada as an example. Morrisons supermarket was taken over by a US private equity group, but that's just two small examples. There have been a lot. I think while this sort of valuation gap persists, I think you're likely to see more takeovers. I think that all I can say is that you're being paid while you wait in the UK stock market. It throws up a very decent dividend yield, and for those who want to be patient, you can enjoy a decent dividend yield and, eventually, in my view, the valuation gap will close, but it could take time.

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Kyle Caldwell: You mentioned the dividend yield and I think the yield on City of London is over 5% now, but equities now face greater competition from other assets, which are viewed as a lower risk, so cash-like investments and bonds, and those yields have risen in response to interest rates going up. So, could you make the case for UK equity income over those two alternatives?

Job Curtis: Yes, I certainly could. The thing about equity income is that it derives from dividends, which derive from the profits of companies to the extent that companies can grow their profits, they can also grow their dividends. So, in the long run, you get dividend growth, while fixed interest, whether it's bank deposits or bonds, is essentially fixed, which is particularly important in a period when you've got inflation. So, in real terms, if you've got a fixed-rate deposit or a bond, if you've got inflation around 8%, within a year, your money has lost 8% of its purchasing power. So, in an equity fund at least you've got the growth in income, which can alleviate that inflationary effect.

Kyle Caldwell: In terms of dividend growth, City of London has a remarkable track record. It is one of eight investment trusts that have increased their dividend payouts each year for over 50 years or more. So, are you on track to deliver a 57th year in a row?

Job Curtis: Yes, we've guided to the market that we will increase our dividend by 2.6% this year, so it will be our 57th year. Obviously, that is below the current rate of inflation, but the board aims to achieve at least inflation over the economic cycle, and over the last 10 years we're well ahead of inflation in terms of our dividend growth, but obviously in certain markets, particularly when you've got very high inflation at the moment, it's quite difficult to get as high as inflation.

Kyle Caldwell: I assume the dividend track record that you've got, both yourself and the board are keen for that to continue for as long as possible, especially as we're approaching 60 years in a short amount of time?

Job Curtis: Yes, absolutely. Obviously at our core, we have consistent companies, companies with leading market positions, with strong brands and kind of moats around their businesses, and that's important. But ultimately, we also have reserves and investment trusts have this structural advantage, [meaning] they don't have to distribute all their income in any one year. So, in the difficult years for income, like we had in the first year of the pandemic, when FTSE 100 dividends were down by around 36%, and bigger outside the FTSE, in that type of year, we were able to draw on our revenue reserves to help continue growing our dividend. There's no way we could have achieved our record without those revenue reserves, and we draw down on them in the difficult years, but in the good years we can put money back into our revenue reserve.

Kyle Caldwell: So, how healthy are the revenue reserves? If you did have a big income shortfall from the underlying holdings, how much of the dividend could those reserves fund?

Job Curtis: Well, they're decent our revenue reserves. They're slightly under half the annual cost of our dividends so they should tide us through on any but the most extreme conditions. There’s also another form of reserves called Capital Distributable Reserves, which basically are the net profits you realised over the years net of any losses you might have made, and those are very substantial. Those are more than three times the cost of our dividend. We certainly wouldn't want to ever use those distributable capital reserves and we don't think it's likely, but they are there as an ultimate backstop.

Kyle Caldwell: As well as the dividend reserves, one of the other bells and whistles that investment trusts have is the ability to gear, which can be very beneficial in a rising market. Your gearing level is currently around 8%. What's the typical range for City of London, and what would need to happen for you to increase gearing levels?

Job Curtis: We've got some very cheap debt which we've issued in recent years during the period of ultra-long interest rates. So, we've borrowed £50 million at 2.94% and £30 million at 2.67%. That's going out for 25 years, so we've locked in some very cheap borrowing rates for our shareholders for the next quarter of a century. So, our fixed-rate borrowings account for around 6% gearing and that remains invested in the market.

Our portfolio is a fairly conservative portfolio and tends to be less volatile than the market, so it lends itself to better gearing in a rising market and we've, as I say, borrowed at very cheap rates. In addition, we have a bank facility where we can borrow short term, and we've reduced that quite markedly recently. Obviously, with the short term, the base rate is now 5% and we're paying a margin over that. It's not quite so attractive to be borrowing short term. So, our gearing is slightly above 6%. We've reduced it really given the higher interest rate environment, but I think the fixed-rate borrowings are very much there strategically for the next quarter century, and I'd be very disappointed if we can't beat those interest rates over that period.

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Kyle Caldwell: And with the gearing levels, are you making a call on the market, or is it when there's new opportunities that present themselves that you use the facility?

Job Curtis: It's a bit of both. As I said, the fixed rate is strategic, a longer-term view, but then the bank facility is more tactical. And if you get a big sell-off in the market and things look really good value again, then we can start using that bank facility, so that would be as opportunities present [themselves], both on a stock level and on a market level.

Kyle Caldwell: And you mentioned that the gearing level is now 6%. How does that compare to the typical average?

Job Curtis: It's at the lower end of our range. Our range is probably around 5% to 6% at the low end to about 14% is probably the maximum it's been in recent years. We’re pretty conservative with the gearing but, as you say, it's one structural advantage investment trusts have, and markets do rise most of the time and it is something that does add to returns.

Kyle Caldwell: You've managed City of London Investment trust since 1991, which is a remarkable track record, and it's very rare, especially nowadays. I'm sure your shareholders don't want you to hang your boots up anytime soon, but I think it'd be remiss of me not to ask, is there some succession planning in place?

Job Curtis: Yes, there definitely is. I love managing City of London and I want to continue to do so. I was only 30 when I was appointed manager, but I work in the global equity income team at Janus Henderson with 12 investment professionals. In particular, I work with David Smith, who is the deputy fund manager of City of London, and he was appointed two years ago. He and I have worked together for over 10 years, and he manages some other portfolios as well. We work very closely and certainly if something was to happen to me, he is absolutely placed to take over.

Kyle Caldwell: Our final question is the skin in the game question, but it's one I've asked you before, so instead I wanted to ask you to explain why you think it's important that fund managers do have some skin in the game and eat their own cooking?

Job Curtis: Yes. Well, I think it's exactly that. You wouldn't want to go to a cook who, if they cooked you a nice meal, then didn't eat it themselves; you might get a bit suspicious. And so, yes, I've got over £1,000,000 in City of London shares and, I'm really pleased to have them. For me, I'm in a stage of my life where I've got the savings to be able to make that. I think it's quite important that a fund manager should have a decent investment in the fund [they] manage.

Kyle Caldwell: Job, thank you for your time today.

Job Curtis: It's a pleasure.

Kyle Caldwell: That's it for this episode, I hope you've enjoyed it. Please do like, comment, and subscribe, and I'll hopefully see you again next time.