The eight income investment trust heavyweights: how sustainable are the dividends?

Eight investment trusts have half a century or more of increasing payouts to investors but deeper analysis is required to ascertain their true income prowess, reports Jennifer Hill. 

A ‘dividend hero’ – an investment trust that has increased its dividends annually for two decades or more – might seem like a dead cert for sustainable income generation. That might appear even more assured for the small selection of trusts that have achieved dividend growth every year for at least half a century.

But dividend growth alone does not make a trust the best home for income seekers’ capital. A deeper delve into the data is needed to make an informed investment decision.

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This feature examines the dividend credentials and sustainability of future dividends for the eight investment trusts that have increased their dividends for 50 years or more: City of London (LSE:CTY), Bankers (LSE:BNKR), Alliance Trust (LSE:ATST), Caledonia Investments (LSE:CLDN), The Global Smaller Companies Trust (LSE:GSCT), F&C Investment Trust (LSE:FCIT), Brunner (LSE:BUT) and JPMorgan Claverhouse (LSE:JCH).

Dividend cover

Dividend cover is the ratio of company’s earnings (net income) over the dividends paid to shareholders. Investment trusts can only retain 15% of their income in revenue reserves, which naturally limits the level of cover.

In years where earnings are higher than dividends paid to shareholders, with some revenues being held in reserve, the figure will be higher than 1. In years where income is lower than dividends paid to shareholders, with revenue reserves being called on to keep the dividend rising, the figure will be lower than 1.

Dividing the revenue earnings per share by the dividend per share during an investment trust’s last full financial year gives an accurate representation of dividend cover for most trusts.

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The exception is Caledonia Investments, a multi-asset trust that sits in the flexible investment sector. It has a different investment profile to the others, with a roughly even split between listed holdings, private equity and funds.

The trust paid a substantial (175p) special dividend last year following some chunky realisations. Including this special dividend would make its dividend cover artificially low because the revenue earnings per share used in the calculation do not include the investment realisation proceeds which are driving it.

Excluding the special dividend from the calculation shows that all eight trusts have dividend cover of around or slightly higher than 1, as illustrated in these figures from Numis Securities.

* Excludes special dividends. Source: Numis Securities.

Revenue reserves

So far, so good. Another, perhaps more illuminating statistic is the revenue reserves as a proportion of a year’s dividend.

The figure for Caledonia looks artificially high. It converted to an investment trust in 2003 and discloses a retained earnings figure, which is different to revenue reserves.

For the others, most of the trusts have substantial reserves – enough to cover almost or more than a year’s dividends. The figures are based on adjusted reserves, which adjusts for dividends related to the year that have not yet been paid.

The exception is City of London, which has less than one-quarter of the dividend declared for its last financial year in reserve. However, its dividend was fully covered by revenue earnings in the year to 30 June 2022, so its revenue reserves are being rebuilt.

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It is also worth noting that investment trusts can use capital reserves to supplement their income following changes in regulation several years ago.

“Therefore, the level of revenue reserves is not necessarily the ‘pinch point’ for whether a fund is able to pay dividends,” says Numis analyst Gavin Trodd.

He adds: “However, boards may be reluctant to use capital reserves, which they may views as less sustainable than using current year earnings, or accumulated revenue reserves from previous years’ excess income.

“That said, several investment trusts have taken the approach of paying a manufactured yield using a portion of capital reserves each year.”

Source: Numis Securities.

Dividend growth

The rate of dividend growth is another important consideration, shedding light on whether a dividend hero has increased its dividends by tiny amounts (well below inflation) to keep its track record going.

The fastest-growing dividends come from global equity proposition Alliance Trust. Alongside City of London and Bankers, it has the longest track record of growing its dividends at 56 consecutive years. Over the past five years, it has achieved dividend growth of 12.77% per annum, data from the Association of Investment Companies (AIC) shows.

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James Carthew, head of investment companies at QuotedData, attributes this to a change in dividend policy.

“Our feeling is that its new dividend policy makes this the trust most likely to be able to support a progressive dividend almost regardless of the investment backdrop,” he says.

“The board seems keen to maintain the trust’s dividend hero status and, beyond its revenue reserves, can also tap into other reserves that should mean it can sustain progressive dividend growth from current levels.

“The board is factoring inflation as well as other factors such as the market environment into its decision-making when it comes to setting an appropriate level of dividend increase.”

Dividend growth has also been meaningful at the other trusts and generally above inflation over the longer term. Although inflation has been stubbornly high of late, at more than 10%, the Bank of England targets inflation of 2%.

Nick Britton, head of intermediary communications at the AIC, says: “While interest rates on cash are increasing, they are still nowhere near inflation and do not offer the prospect of growing income over time.

“An investment in a dividend hero investment company has the potential, over the long term, to protect your capital from the ravages of inflation as well as providing a growing income from year to year.”

Source: theaic.co.uk/Morningstar.

Yield

Just because an investment trust makes it on to the dividend heroes list, does not mean it is a high-income investment. In fact, many of those on the list have modest yields of 2.5% or less (with all yield figures source in mid-April).

Global Smaller Companies has the lowest yield at 1.29%. That is unsurprisingly given its focus on smaller companies, which tend to reinvest profits in their businesses instead of returning them to shareholders.

Conversely, City of London and JPMorgan Claverhouse, which both invest in the traditionally strong income market of UK equities, have the highest yields, at 5.02% and 4.87%, respectively.

A combination of relatively low reserves relative to dividends and slow dividend growth is taking the shine off City of London for some analysts.

Peel Hunt analyst Tom Pocock notes that earnings for the half-year period to end-December 2022 fell slightly, by 1.7%, because mining company payouts declined from the elevated levels seen in 2021.

“The trust’s scope to maintain the current dividend might be limited if the underlying revenues were to reduce significantly,” he says.

Carthew at QuotedData adds: “Our feeling is that the appeal of this investor favourite might fade in time.”

Source: theaic.co.uk/Morningstar.

Preferred picks

City of London is on interactive investor’s Super 60 list of investment ideas. Dzmitry Lipski, head of funds at interactive investor, believes its combination of an exceptionally experienced and long-tenured manager in Job Curtis and a consistent process makes it compelling for investors seeking a core UK equity income option.

The portfolio is diversified across nearly 90 predominantly large-cap holdings and the board has guided to its 57th year of dividend growth for 2023 on the back of recent strong dividend increases from bank and oil companies.

F&C, run by multi-asset specialist Paul Niven, is another interactive investor pick, categorised in the Super 60 as a core global equity choice, rather than income, due to its relatively low yield and mandate to generate both capital growth and income from publicly listed and private equity globally.

“Niven’s pragmatism combined with a well-executed approach have served investors well over the long term,” says Lipski.

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Trodd at Numis and Carthew at QuotedData both rate the income credentials of JPMorgan Claverhouse.

“Holders benefit from capital growth as well as income through a barbell approach, which offers exposure to both value and growth ends of the market,” says Trodd.

The trust’s dividend yield is the second highest of this group, reflecting how out of favour the UK market is with global investors.

“Our feeling is that this might be the trust in this peer group to back if you feel that the UK is likely to be re-rated,” says Carthew.

For investors seeking sustainable dividends, Pocock at Peel Hunt highlights the ‘hidden hero’ of Law Debenture (LSE:LWDB).

It is a next generation dividend hero, with 13 years of consecutive income increases. However, it has a longer track record of 44 years of growing or maintaining its dividends. Around 20% of the portfolio consists of an ownership stake in an independent professional services (IPS) business.

“This business has driven income growth in the trust with 11% annualised net revenue growth from IPS contributing to a 114% increase in the trust’s dividends over the past 10 years,” says Pocock.

“Furthermore, the high level of contracted or repeat revenues in the IPS business provides the board with significant visibility on cash flows and allows James Henderson and Laura Foll, managers of the UK equity portfolio, greater scope to invest in an unconstrained manner.”