The role of the UK as a leader in global income is well established. It has a very healthy shareholder return culture. The City of London Investment Trust seeks to make the most of this dynamic by identifying companies that, its managers believe, can grow their dividends into the future.
However, the UK income market has been through a period of turmoil. Prior to the Covid-19 pandemic, special dividends rose over a multi-year period. Since then, buybacks have become standard for many UK businesses. How does a company with 58 years of consecutive dividend growth navigate these changes?
Consistency is key
The first thing to note is that the trust’s managers have kept a consistent approach to special dividends. They have always treated these as exceptional, rather than as part of the trust’s core income, even as they became an apparent fixture in the late 2010s. As such, these payments were used to top up the trust’s revenue reserve – a portion of which was subsequently used to maintain dividends during the pandemic.
Now, special dividends have fallen by the wayside. In their place, companies are increasingly opting to buy back their shares.
Two competing factors are fuelling this trend. Firstly, UK shares are historically cheap relative to the amount of revenue that companies are bringing in. Second, many UK companies are seeing their revenue continue to grow, despite economic doom and gloom. Combined, this means that companies are looking for something to spend their extra cash on. In many cases, the cheapest thing for them to buy is their own shares.
Balancing buybacks
This could be a challenge for income investors, as a buyback is a one-off return to shareholders. Meanwhile, income investors by their nature are seeking repeated payments over time. To navigate this, City of London’s managers aim to identify businesses that can continue to grow their dividends while conducting buybacks.
Indeed, an advantage of share buybacks is that they shrink a company’s overall shareholder base. Paying and increasing dividends are then cheaper for the company over time.
The most obvious examples of this trend are companies whose shares have fallen out of favour in recent years.
For example, Shell has at times fallen foul of both being an oil major in a renewable-inducing world and UK-listed. Its shares are significantly cheaper than those of its US peers ExxonMobil and Chevron. As a result, the company opted to pay back 7% of its shares in 2024. It also increased its dividend by 4.1%.
Another example in the portfolio is tobacco giant Imperial Brands. It has become the marginal buyer of its own shares, given that it is still generating significant cash revenue.
While buybacks are not inherently positive for income investors like The City of London Investment Trust, in the current environment – and when paired with sensible dividend increases – they can enhance income overall.
