The City of London Investment Trust has grown its dividend every year since 1966 – a record for any investment trust. How has it achieved this 52-year track record – and how is it positioned for future dividend growth?
City of London seeks a core portfolio of high-quality companies which grow profits and dividends consistently.
The aim is to find companies that cover their dividends with cashflow and profits, and retain enough to invest for long-term growth.
Different industries and companies have different investment needs.
Those in a high-growth phase may need to keep a lot of cash for investment. More mature companies may be able to pay more retained profits to shareholders as dividends.
It is important to check what is being accounted for, as profit equates to the cash actually earned by a business. A company must generate cash to pay regular dividends.
Another important feature to consider is a company’s indebtedness.
Companies with high debts are more likely to cut dividends in a downturn because they have to prioritise interest payments.
Companies in stable sectors are more suitable for leverage, which can enhance returns for equity holders.
Leverage is less appropriate for companies in sectors that suffer sharp drops in activity.
Discipline, diversification and dividends
In general, paying and growing a dividend is a helpful discipline for corporate management against which to judge acquisitions and capital expenditure projects.
During the oil price downturn in 2015 and 2016, BP and Royal Dutch Shell maintained dividends by cutting capital spending and operating more efficiently.
In terms of portfolio construction, diversification across sectors and stocks is helpful. It grows dividends and capital gains consistently.
This goes back to the principle of not having ‘all one’s eggs in one basket.’
While a portfolio manager will want definite biases in a portfolio, too extreme a position can lead to volatile performance. For example, a portfolio purely of defensive stocks will significantly lag the market during a cyclical upswing of the economy.
The investment trust structure is a definite advantage in delivering consistent dividend growth.
While open-ended trusts must distribute all their income once a year, investment trusts can retain up to 15% which is added to the revenue reserve.
The revenue reserve can be drawn down during difficult years for dividends in the equity market, enabling an investment trust’s dividend to continue growing.
In 27 years since Job Curtis became City of London’s fund manager, he has used the revenue reserves seven times to keep the dividend growing.
City of London’s portfolio balances three key areas to generate income and capital growth.
1. Consumer staples
1 Consumer staples, where the companies are global and record consistent profits.
They sell basic, everyday items and in the long run should grow in emerging markets as vast populations become more affluent.
Three consumer staples companies are among City of London’s largest 10 holdings: Diageo, the world-leading alcoholic drinks company with brands such as Johnnie Walker and Guinness; British American Tobacco and Unilever.
2 Oil, with Royal Dutch Shell, City of London’s largest holding, and BP, the third largest.
We believe that the outlook is positive over the next few years given growing demand for oil and natural gas, especially from emerging markets.
More importantly, both Royal Dutch Shell and BP have significantly improved the efficiency of their operations in recent years, bringing down the oil price needed to cover their dividends.
3 Banks, where there are two holdings in City of London’s top 10: HSBC and Lloyds.
HSBC is global but most of its profits come from the Asia Pacific region.
Lloyds is completely focused on the UK.
Both banks have strong capital ratios (reserves versus risky assets) and offer an attractive combination of dividend yield and growth for a relativity modest share price valuation.
Banks tend to benefit from rising interest rates, as they achieve better pricing on their deposits. HSBC has already seen some benefit from a rise in US rates and if UK interest rates continue to go up, it would be a positive trend for Lloyds.
Bricks and mortar
Another important area for City of London is property, with interests in Real Estate Investment Trusts (REITs) and homebuilders.
REITs own properties and can pass through rental income to dividends without paying tax, which is an attractive structure for an income fund to own.
REITs owned by City of London, such as Land Securities and British Land, own prime UK office and retail property. At time of writing their share prices stand at significant discounts to the valuation of the properties they own. That reflects Brexit-linked nervousness about the outlook for London offices, which are a major part of their portfolios.
There are concerns over structural issues for retail property but we believe the prime destination shopping centres owned by Land Securities and British Land have a prosperous future. The discount ratings offer an opportunity for investors and the REIT sector should benefit if there is a satisfactory Brexit outcome.
Sentiment towards housebuilders has also been affected by Brexit. But we believe that there is latent demand for home ownership across the UK.
The housebuilders owned in the portfolio - Taylor Wimpey, Persimmon and Berkeley - are well placed to meet this demand with their strong balance sheets and extensive land ownership available for homebuilding.
All in all, the UK equity market is an attractive opportunity for dividend income from a variety of sectors.
The investment trust structure is well placed to aim for consistent annual dividend growth in line with City of London’s 53-year record.
It is important to select companies that are able to cover their dividend and invest enough to grow sustained profits.
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