The Association of Investment Companies (AIC) was founded in 1932 to further the interests of the investment trust industry – the oldest form of collective investment. Today, it represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and Venture Capital Trusts.
Every year, in March, the AIC publishes its list of 'Dividend Heroes', featuring those investment trusts which have succeeded in increasing their dividend payouts for a consecutive period of 20 years or more. At a time when market conditions are challenging, and with interest rates sliding, the reliability of income streams is even more important.
Making the AIC's hero list is no small achievement. In its latest annual analysis, published on 16th March 2020, of the 362 trusts whose dividend records were analysed, only 21 – ie circa 6% - succeeded in doing so. 1
53 years of continuous dividend growth
Four investment trusts occupy even more elevated territory – those which have increased their dividends for at least 50 years, a truly remarkable achievement given the decidedly choppy waters they will have been forced to navigate on multiple occasions over that period of time – the global financial crash of 2008, the dot-com bubble of 2001; and the failure of hedge fund Long-Term Capital Management in 1998, to name but three. Of these four trusts, two are within the Janus Henderson stable: The City Of London Investment Trust (established in 1861) and The Bankers Investment Trust (established in 1888), both with 53 years of consecutive increases.2 That's going back a bit: to place it into perspective, 1967 saw The Beatles release Sergeant Pepper's Lonely Hearts Club Band and the world's first heart transplant operation performed by Dr Christiaan Barnard.
Whilst judicious asset allocation and shrewd stock-picking will have contributed significantly to this enviable record of dependable and growing dividend performance, Job Curtis , fund manager of City of London, emphasises that it could not have achieved 53 years of continuous dividend growth without taking full advantage of a unique benefit applicable to the closed-ended structure: income reserving. Unlike their open-ended counterparts, investment trusts are permitted to retain up to 15% of the income they generate each year, enabling them to 'store' income in good years in order to bridge any shortfalls in more turbulent ones, a 'rainy day' facility which gives them a significant advantage when it comes to providing investors with consistent dividend growth.
The power of income reserving
In the 28 years that Job has been managing City of London, he has accessed the trust's revenue reserve on seven occasions – one year in four. He rightly points out that even the very largest companies can have sudden severe problems, citing BP's suspension of its dividend in the wake of the 2010 Deepwater Horizon oil disaster in the Gulf of Mexico, considered to be the largest marine oil spill in the history of the petroleum industry, as a prime example.
Job’s view of the benefits of income reserving is shared by Alex Crooke, fund manager of Bankers Investment Trust, although Alex points out that global reach is a further advantage, offering access to more areas of growth when certain sectors or countries are stumbling. The revenue reserve built up in strong years enables the trust to cope with the fluctuations of currencies or the need to prioritise asset allocation decisions towards lower yielding markets.
Growing dividends to total return
Whilst there will inevitably be large numbers of income-seeking investors who require an above average yield from their assets, others will be keen to explore opportunities on the basis of their total return, i.e. a combination of both sustainable dividend income and capital growth over the longer term. It's pertinent, therefore, to consider to what extent rising dividend income over a protracted period acts as a strong driver of investment trust pricing and, therefore, as a contributor to overall returns. Indeed, both Job and Alex adhere firmly to the view that dividend yield and dividend cover (the ratio of earnings, ie net income, over the dividend) represents the essential starting-point for any fundamental equity valuation.
Returning to the question of overall returns, the superiority of equities over both bonds and cash – over the long term – is well-recognised. In The Barclays Equity Gilt Study 2019, the nominal performance of £100 invested in cash, bonds or equities (the All-Share Index) between 1899 and 2018: cash would be worth just over £20,000 today; if invested in gilts, the same £100 would be worth close to £42,000; however, £100 invested in equities in 1899 would now be worth around £2.7m.1
This provides empirical support for the axiom that time in the market is far more important than timing the market, and amply demonstrates what fine long-term investments shares are, both in absolute and real (ie after allowing for the effect of inflation) terms: UK stocks have returned 4.9% a year in real terms since the inception of the Barclays study.
For most people, the investment horizon is rather shorter than the period we’ve analysed above, which begs the question: “What is the probability of equities outperforming cash or bonds?” Again, the Barclays Equity Gilt Study provides the answer. The probability of equities beating cash or bonds over any consecutive two-year period is 69% and 68% respectively; extend the term to 10 years, however, and your chances rise to 91% and 77%.
The eighth wonder of the world
Furthermore, what is less well-appreciated, however, is the degree to which that impressive outperformance has been driven by the relentless power of the dividend component. In short, income is crucial.
For illustrative purposes only, assume an investor buys 10,000 shares in ABC plc at a cost of 100p per share with an annual dividend yield of 5% (5p per share). Over the next 20 years, if the price and dividend remain the same, they would have received an annual dividend of £500. At the end of the 20-year period, the shares would still be worth £10,000 and they would have received £10,000 in dividends for a total of £20,000. If, over the same period, they had reinvested their annual dividend of £500, the initial £10,000 investment would now be worth £26,532. Moreover, at the end of this period, they could receive an annual dividend of £1,326.60. This means the yield on the initial investment of £10,000 has effectively increased to over 13%.
Let’s return to the Barclays study. As we've seen, £100 invested in UK equities in 1899 would now be worth around £2.7m. However, if the contribution of the dividend component is stripped out, that value falls dramatically to under £20,000 – less than 1% of the amount with dividends reinvested. Reinvesting dividends to buy more shares enables you to benefit from the effects of compounding … or what Einstein called the "eighth wonder of the world”.
1 AIC/Morningstar, 16th March 2020
2 Barclays Research, Equity Gilt Study, 11th April 2018