The City of London Investment Trust has grown its dividend every year since 1966, which is the longest record of any investment trust. How has this 52-year record been achieved? How is the portfolio positioned for dividend growth going forward?
City of London seeks to have at the core of its portfolio quality companies which are able to grow their profits and dividends consistently. The aim is to find companies that cover their dividends with cash flow and profits and retain enough to invest for the long-term growth of their business. Different industries and companies have varying investment needs. Those in a high growth phase may need to retain a lot of cash for investment. On the other hand, more mature companies may be able to hand back a greater proportion of their retained profits to shareholders as dividends. It is important to check what is being accounted for as profits equates to the cash actually earned by a business. A company needs to generate cash to be able pay its dividend on a sustained basis.
Another important feature to consider is the level of a company’s indebtedness. Companies with high debts are more likely to cut their dividends in a downturn because they have to prioritise interest payments. Companies that are in stable sectors are more suitable for leverage which can enhance returns for equity holders. Leverage is less appropriate for companies in sectors that are susceptible to sharp drops in activity.
Discipline, diversification and dividends
In general, we believe that paying and growing a dividend provides a helpful discipline for corporate management against which to judge acquisitions and capital expenditure projects. During the downturn of the oil price in 2015 and 2016, BP and Royal Dutch Shell were able to maintain their dividends by cutting capital expenditure and operating more efficiently.
In terms of portfolio construction, diversification across sectors and stocks is, in our view, helpful for providing consistent dividend growth as well as capital gains. This goes back to the principle of not having ‘all one’s eggs in one basket.’ While a portfolio manager will want to have definite biases within 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 have to distribute all of 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 the 27 years since I became City of London’s fund manager, we have used the revenue reserves seven times to keep the dividend growing.
Looking at City of London’s portfolio, we have a balance of key areas with the aim of generating income and capital growth. First, the consumer staples sectors, where the companies are global and have a record of consistent profitability. They sell basic, everyday items and in the long run should benefit from secular growth in emerging markets as vast populations become more affluent. Among City of London’s largest ten holding are three consumer staples companies: Diageo, the world leading alcoholic beverages company with brands such as Johnnie Walker Scotch Whisky and Guinness; British American Tobacco and Unilever.
A second key area is the oil sector with Royal Dutch Shell — City of London’s largest holding — and BP, the third-largest. While the oil price has recently fallen, 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.
A third key sector is banks where there are two holdings in City of London’s top ten: HSBC and Lloyds. HSBC is a global bank but with the majority of its profits coming from the Asia Pacific region. On the other hand, Lloyds is completely focused on the UK. In our view, 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 the rise in US rates and if UK interest rates were to continue to go up, it would, in our opinion, be a positive trend for Lloyds.
Bricks and mortar
A fourth important area for City of London is property related being Real Estate Investment Trusts (REITs) and homebuilders. REITs own properties and are able to pass through the 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. Their share prices are currently standing at significant discounts to the valuation of the properties they own which reflects nervousness about the outlook for London offices, which are a major part of their portfolios, ahead of Brexit. In addition, there are specific concerns over structural issues for retail property but we believe the prime shopping centres owned by Land Securities and British Land are destinations and have a prosperous future. The discount ratings appear to offer an opportunity for investors and the REIT sector should be a beneficiary if there is a satisfactory Brexit outcome.
Sentiment towards housebuilders has also been affected by the vicissitudes of Brexit. However, we believe that there is latent demand for home ownership across the UK. The housebuilders owned in the portfolio, which are Taylor Wimpey, Persimmon and Berkeley, are well placed to meet this demand with their strong balance sheets and extensive land ownership available for new homes to be built upon.
All in all, the UK equity market, in our view, offers an attractive opportunity for dividend income from a variety of different sectors. The investment trust structure is well placed to aim for consistent annual dividend growth as demonstrated by City of London’s fifty-two year record. It is important to select companies that are both able to cover their dividend and invest enough to grow their profits on a sustained basis.