Dividend Survivors: top 10 UK Equity Income trusts
Investors looking to generate income from the UK stock market are having a tough year. The coronavirus epidemic has triggered a dividend crisis with payouts from British companies set to plunge 40% as businesses conserve cash, while they and their customers are in lockdown, by suspending or cutting dividends.
UK equity income investment trusts – on which many income investors rely – have been hit hard. Their shares have tumbled in the stock market crash while the levels of income they receive this year – and quite possibly the next two – have collapsed.
Fortunately, most of the trusts have substantial reserves of income they have previously received from their investments but not distributed to investors. They can use these reserves to subsidise their dividends and possibly avoid having to cut their payouts to shareholders.
In this article we pick 10 of the 24 trusts in the UK Equity Income sector we think are best positioned to maintain their dividends and deliver good overall returns to investors.
Investment trusts in the Association of Investment Companies’ (AIC) UK Equity Income sector are the last hope for distressed investors seeking to generate income from companies on the London Stock Exchange during the current unprecedented dividend crisis caused by the coronavirus pandemic.
Although many of these trusts suffered steep falls in their investments in the stock market crash in late February and March and are set to receive much lower levels of income as British firms slash dividend payments in response to the recession caused by the Covid-19 outbreak, they have one BIG advantage over rival open-ended investment companies, or funds: revenue reserves.
Unlike open-ended funds, which must pay out all the investment income they receive in a year, so-called ‘closed-end’ investment trusts can retain up to 15% of their investment income each year. Over many years this has allowed them to accumulate money they can distribute when investment income has fallen and their own dividends are under pressure. It is the presence of revenue reserves that has enabled a UK equity income trust like City of London (CTY) to raise its dividends for a record 53 years in succession, and why the AIC trade body has been able to proclaim 21 trusts in the industry as ‘Dividend Heroes’ for establishing unbroken track records for over two decades.
It is also worth remembering that many investment trusts are authorised to pay dividends from capital if they wish to. Although this practice – which effectively means selling investments in order to generate an income – is not universally popular, it does give trusts a lot of room for manoeuvre if they wish to avoid a dividend cut. JPMorgan Claverhouse, third on our list below, does not have permission to do this, however.
To assist you in your search we have winnowed the sector down to 10 trusts that seem to us best positioned. High-yielding trusts that have been worst affected by the dividend cuts so far, such as Aberdeen Standard Equity Income (ASEI) and Merchants (MRCH), have been put to one side.
We have also left out trusts below £100m as their small size can make them more expensive to own or buy and sell. Where a fund management group runs more than one investment trust, we have picked the one we like best.
We have also left out two well-known investment trusts undergoing a change in fund manager and the uncertainty that brings: Perpetual Income & Growth (PLI) is in the process of appointing a new fund manager after dismissing Invesco and its former head of UK equities Mark Barnett; and Temple Bar (TMPL) is seeking a successor to Alastair Mundy, its long-standing fund manager whose departure on sick leave in April prompted its board to give his employer Ninety One six months’ notice on its contract.
But which of the 24 trusts in the UK Equity Income group should you choose? Revenue reserves vary a great deal as does the approach of investment trust boards on how and when to use these income surpluses to subsidise their dividends. In addition, investment trusts’ exposure to the dividend crisis and their style of stock picking also affects returns. While their dividend yields of around 4% to 8% look attractive, these are historic figures and may decline if payouts are reduced.
Our top choice of Finsbury Growth & Income (FGT) is a bit more surprising than it first appears. The £1.7bn trust is famous for its sector-beating returns. Under Nick Train (pictured), its fund manager since 2000, as of 12 June Finsbury Growth led the UK Equity Income pack over five and 10 years with total returns of 52.5% and 276%, way ahead of the sector averages of 0.9% and 100% and also the UK stock market returns of 8.6% and 80.5% over those periods.
Yet, impressive as these statistics are, Finsbury Growth offers a low dividend yield of just 2% compared to the 4.9% sector average. That’s not an indication, though, that Train is shirking his duty to find dividend stocks. The trust’s semi-annual dividends have grown at a decent 8% a year since 2015, the fact the shares yield so little is testament to the strong capital returns many of his income stocks have produced because of the consistent growth in income they generate.
It’s also striking that despite its dominance of its peer group, Finsbury Growth is not one of the AIC’s ‘Dividend Heroes’, having last cut its dividend in the 2008 financial crisis. Perhaps this frees Train to look at the bigger picture and consider investors’ overall returns rather than just their income line. Certainly in the trust’s half-year results in May, Train sounded sanguine about the prospect of widespread dividend cuts, urging companies to ‘do the right thing’ and save their money if it helped them survive and prosper.
Train could afford to be relaxed. Although badly knocked in the crash, the Finsbury portfolio suffered far fewer dividend cuts than its rivals due to its concentrated holdings in high-quality, financially strong growth stocks such as consumer goods giant Unilever, Guinness and spirits group Diageo, wealth manager Hargreaves Lansdown and the London Stock Exchange, with zero in oil and banks where dividend reductions initially focused.
As a result, after a strong market recovery, up to 12 June the shares had only fallen 8% this year, in contrast to the near 19% slide in the FTSE All-Share index. Meanwhile, revenue reserves equal to 0.9 year’s of last year’s dividend leaves the payout well supported.
The trust also eschews the use of gearing – or borrowing that many trusts use to boost returns – which makes its shares less volatile and a bit more defensive when stock markets are troubled as they are now. ‘We believe that the approach is particularly well suited to the current environment when companies with “survivability” are likely to be highly valued by investors,’ commented Numis Securities. ‘Given its strong long-term track record and differentiated approach, we view Finsbury Growth & Income as one of our favoured UK equity funds,’ it added.
The £378m Dunedin Income Growth (DIG), whose launch dates back to 1873, went into the crisis in a strong position having been steadily shifted in recent years by fund managers Ben Ritchie and Louise Kernohan (pictured) from higher-yielding value stocks to lower-yielding ‘quality growth’ shares.
As a result analysts found a comparatively low 15% of its holdings cut or suspended dividends at the height of the crisis in April. At the end of that month its top two positions were drugs companies GlaxoSmithKline and AstraZeneca, followed by a more unusual stake in GP surgery and medical centre owner Assura adding to the defensive healthcare theme. This has limited this year’s share price declines to 11%, second best to Finsbury Growth, although ten-year returns of 128% fall well short of Train’s trust.
‘Given that we were already positioned conservatively heading into this crisis, portfolio changes in recent weeks have been relatively modest,’ Kernohan told us. ‘In particular, experience has taught us to be particularly wary of chasing yield at the expense of total return.’ Stocks that had done well were trimmed and the proceeds invested in ‘companies we believe will be relatively resilient but where share prices have declined sharply, such as Coca Cola, SSE and Direct Line Insurance,’ she said.
In April the 5%-yielder declared a fourth quarterly dividend of 3.7p, lifting the total for 2019/20 by 2% to 12.7p per share. Although the board noted revenue per share was declining in response to the fund managers’ rebalancing, it said this laid the foundation for faster dividend growth in future and improved capital returns. The policy of growing the dividend ahead of inflation in the medium term was also reiterated.
The £335m JPMorgan Claverhouse (JCH) has the second highest level of revenue reserves in the sector, according to Numis analysis, equal to 1.2 years of last year’s quarterly dividends. At annual results in March, the company declared its 47th year of dividend growth, with fund managers William Meadon and Callum Abbot comparing the reserves to a ‘fortress’ in which investors could shelter in the dividend storm.
The FTSE 100 focused portfolio has slumped 24% this year, despite a weighting to defensive sectors like healthcare and utilities, leaving it yielding just over 5%. It has also dented the long-term performance, although a 10-year total return of 112% comfortably beats the FTSE All-Share’s 80.5%. Unusually, the setback prompted its board of non-executive directors to cut their fees by 20%.
Speaking on Citywire’s Funds Fanatic podcast this month Meadon (pictured) expressed optimism that many companies would resume dividends and pay out the income investors had missed, arguing it was ‘paradise postponed, not lost’. Nevertheless, with no end to the pandemic in sight and stock market uncertainty elevated, the managers are cautious and have reduced gearing to under 6% in April from 9% in January. There is further reassurance from the board’s policy of using share buybacks to try and ensure the share price does not fall below a 5% discount to net asset value.
For a long time this 130-year investment trust languished in relative obscurity, with some investors unsure of what to make of a company that operates a professional services business alongside a conventional equities portfolio run by James Henderson (pictured) and Laura Foll at Janus Henderson. In the past two years, however, Law Debenture (LWDB) has moved to take advantage of its unusual structure under chief executive Denis Jackson.
Revenues from the pensions trustee and bond administration divisions generate a third of the company’s income, underpinning the work of its equity income fund managers and providing 1.3 years of dividend cover from its reserves, the highest in its sector. This led to a ‘step change’ in dividends this year with a 50% increase in the final dividend and a commitment this month to at least maintain quarterly dividends this year at the same level as 2019.
The big question mark for the 5% yielder hangs over the portfolio, which while widely diversified has been held back by the managers’ ‘value’ philosophy of picking cheap stocks, a style that has been out of favour in the growth bull market of the past decade and has left it exposed to this year’s tidal wave of dividend cuts. Gearing of 17% is high and also makes it vulnerable to short-term market turbulence, although potentially benefiting from a long-term recovery in the financial and industrial stocks in which they are overweight.
Also, with the support of the financial services businesses, the shares’ 18% fall this year has at least been no worse than the FTSE All-Share, and over 10 years their total return of 158% is nearly double that of the benchmark index.
Now for something different. Diverse Income (DIVI) is the only investment trust in our list with a so-called ‘multi cap’ approach under which it invests in dividend stocks across the entire UK stock market. This means it has over 43% allocated to small companies, such as top holding Highland Gold Mining, and just 26% in FTSE 100 stocks, which is very low compared to the blue-chip focused trusts that dominate the UK equity income scene.
For a relatively new trust launched nine years ago, the £282m Diverse Income has built up £9.3m of revenue reserves. Although the 0.6 year’s dividend cover they provide is on the low side compared to rivals, its board recently committed to use them to maintain this year’s dividends at last year’s level.
The reason for its inclusion here is 4.8%-yielding Diverse Income offers investors much-needed diversification within the UK at a time when income seekers have discovered the danger of relying too much on former dividend stalwarts such as Shell, the oil giant this year forced to slash its dividend for the first time since the Second World War.
Secondly, after a long period when its performance was weighed down by concerns over what Brexit would do to its small- and mid-cap stocks, Diverse Income has bounced back. A share price decline of 17% so far this year masks a more resilient underlying performance from the portfolio with net asset value down under 10%, the second-best performance in the sector. ‘We came in with a much more defensive mix in terms of the assets and balance sheets,’ said Gervais Williams (pictured) who runs the trust with Martin Turner. ‘The positioning hasn’t actually changed very much,’ he said.
City of London (CTY) is zealous of its remarkable dividend track record. Philip Remnant, the £1.4bn trust’s chair, was quick out of the blocks in early April to declare the trust would use its reserves to lift the final dividend in July and extend its record period of rising payouts to 54 years.
There is no doubting the determination to protect the dividend in the short term. However, a long-lasting dividend drought of several years could prove challenging for the 5.7% yielder. While the board has increased revenue reserves in recent years, share issuance by this popular trust means the amount it has to pay in dividends has increased, thereby reducing dividend cover from these surpluses from 0.8 year’s to 0.6, less than others on this list.
Nevertheless, City is still regarded as a ‘core’ holding for UK equity income investors. Fund manager Job Curtis (pictured), a cautious value investor, has run the blue-chip portfolio for nearly three decades and is experienced at tilting it away from trouble. Although a 22% share price drop year to date has flattened five-year returns below that of the All-Share, over 10 years shareholders have received an index-beating total return including quarterly dividends of 110%. The manager also diversifies outside the UK with 14% of assets in overseas dividend stocks, such as Microsoft.
Julian Cane, fund manager of BMO Capital & Income (BCI), is braced for the worst believing UK dividends could halve this year compared to 2019. However, with one year of revenue reserves, investors in the £280m trust can be fairly confident it will at least maintain the total of quarterly dividends at last year’s level, having achieved 26 years of consecutive increases in payouts.
At the half-year stage this month dividends were up 2% on last year at 5.2p per share, with the board stating it would ‘continue to monitor the company’s use of reserves, mindful of shareholders’ desire for income in addition to capital growth - particularly during these challenging times.’
By early April about one third of the portfolio had cut dividends. Despite a 35% weighting in financials, exposure to payout-cutting banks was low. Cane, who operates a growth-at-a-reasonable-price approach, told Investment Trust Insider he was looking to support companies with good long-term prospects, irrespective of whether they paid dividends in the short term. ‘We will not be investing in companies just to chase dividend payments as we believe this would be to the longer-term detriment of our performance and we are in a strong enough position that we don’t have to,’ he said.
The 4.3%-yielding shares have tumbled 23% this year but over 10 years are ahead of the FTSE All-Share with a 104.5% total return.
Like BCI, Schroder Income Growth (SCF) has raised its annual dividends every year since launch, or 1995 in its case, and also has reserves to cover almost all of last year’s quarterly distributions. Sue Noffke (pictured), fund manager and Schroders’ head of UK equities, operates a concentrated portfolio of around 40 stocks with her top 10 holdings, such as GlaxoSmithKline, British American Tobacco, BAE Systems and Tesco, accounting for over half of the £169m trust’s assets.
About a quarter of its companies are thought to have cut dividends by early April, including Lloyds bank. The 5%-yielding shares have slid 22% this year as like other fund managers Noffke was positive on the UK after the general election in December, and when the crisis struck was fairly highly geared. That borrowing left her with 12% cash to go bargain hunting as markets recovered. Since taking over in 2011, Noffke has made the portfolio more growth oriented. Over 10 years the trust has generated a total return for shareholders of 111%.
We end our shortlist with two outliers. First is Troy Income & Growth (TIGT), a defensive trust that may have successfully taken pre-emptive action. It is the only trust to have narrowly missed generating sufficient earnings in its last financial year (2018/19) to cover its dividend. It has comparatively low revenue reserves covering just 0.7 of that year's dividend. In May it said that while dividends for the current 2019/20 year to 30 September would likely rise by 1.5%, it was probable payouts would subsequently be cut.
All that may sound unpromising but in fact reflects the fact that, like their counterparts at Dunedin Income Growth, Troy Income managers Francis Brooke (pictured) and Hugo Ure had rebalanced the portfolio and replaced high-yielding stocks with vulnerable dividends with lower-yielding stocks with faster-growing earnings or profits. When the crisis struck, less than 10% of their holdings immediately cut or suspended shareholder payouts. As a result, the 3.8%-yielding shares had fallen just over 12% by 12 June, while their total returns over five years stood at a highly credible 21% and 132% respectively.
If we’re prepared to countenance a potential dividend cutter like Troy Income, then it’s only a small step to include the £817m Edinburgh (EDIN), which may have begun a period of rehabilitation under new fund managers James de Uphaugh and Chris Field of Majedie Asset Management. The duo took over in March after its board had sacked Invesco after a long period of poor performance by its former manager Mark Barnett.
This month the company lifted annual dividends for the 15th successive year but cautioned that its policy was under review and indicated that dividends could fall as it moved to rebase payouts to a sustainable but progressive level.
It’s early days but with the managers describing themselves as pragmatic investors – open to holding both ‘growth’ and ‘value’ stocks – and having overhauled the portfolio so it was less exposed to dividend cuts than the average trust in its sector, the 6%-yielder may hold promise, particularly as it holds nearly one year of dividends in revenue reserves. On a 12% discount to net asset value, having fallen 24% this year, they’re certainly inexpensive.
