Two FTSE 100 high-yielding shares that stand out from the crowd

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to the latest in our Insider Interview video series. Today, I'm joined by Job Curtis, fund manager of the City of London (LSE:CTY) Investment Trust. Job, thanks for coming in today.

Job Curtis, fund manager of the City of London Investment Trust: It's a pleasure.

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Kyle Caldwell: in response to the volatile market backdrop, dividend investing is becoming fashionable once again. I was wondering if you can explain why that's happening. Also, could you name a couple of stocks that you own that are among the highest yields in the trust?

Job Curtis: Yes. Over the very long run, dividends pay a very important part of the total return. People forget about it. People get much more obsessed with how much shares go up. But in terms of the total return, given in periods when shares go down, the actual dividend pays a very important part. I think people have noticed it more this year because it's been a different type of market, it hasn't been led by the growth stocks. It's actually being quite volatile. Parts of the market have gone down. So at least with the dividend, you get a proper return. You get some cash coming into your bank account. So, I think people do appreciate the dividend more. Despite the better performance of dividend paying into the market, there are still great opportunities out there. I mean, just looking at City of London's portfolio, two come to mind immediately.

Our biggest holding is British American Tobacco (LSE:BATS), a very unfashionable sector for obvious reasons, but BAT has got a dividend yield of over 6%, and it's covered by its cash-flow generation, its free-cash flow by yield of over 10%. So, it's a well-covered dividend. The biggest market is the US; they're doing very well over there. But the interesting thing is that they're doing well in cigarettes, but they also are growing rapidly their portfolio of less-harmful products and they are now the slight leader in America in vaping. They've overtaken Juul in the US, so they're definitely planning their business for a future of less-harmful products, which is a good thing to see. 

Another stock I could mention from the portfolio, which is on a very attractive yield of over 7% is M&G (LSE:MNG), which is a mixture of a fund management company and a legacy life business and they've got something called the PruFund, which is a kind of with profits diversified fund, which invests in a mixture of equities, bonds, [and] alternatives, which they're the market leader in and it's a big fund. It's basically a system whereby shareholders of M&G will get 10% of the profits when policyholders eventually cash in their products. So that means there's a lot of long-term cash generation and I think the dividend is well covered by capital, so it's one I like at the moment. It came out of Prudential where it was a demerger a couple of years ago.

Kyle Caldwell: And what's your outlook for UK dividends for, say, the next 12 to 18 months? I mean, on the one hand, we have the potential of further interest rate rises to try and cool inflation. But then there's also the prospect of a recession occurring if those interest rate rises are perhaps too aggressive. I assume that all those factors are headwinds for dividends?

Job Curtis: If you look back, we had a terrible time at the beginning of the pandemic and that sort of second quarter of 2020. There was a huge number of dividend cuts across the UK market and other markets, some by companies which were forced to cut their dividends like the banks by the regulators, others where their businesses had literally stopped and they were in no position to pay a dividend. There are others where companies might have been over-distributing for a few years and it was an opportunity to smoke-screen, to sort of reduce their dividend payout, to a sort of more affordable level.

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Since that point, we've had a massive recovery in dividends, I'm pleased to say, and dividends are now slightly above pre-pandemic levels across the whole market. The biggest sector has been the mining sector where we have some big global miners listed in London and they've benefited from booming prices of commodities such as iron ore and copper. I mean, going forwards, if anything, some of those prices are abating a bit. So, I’m probably looking at less good dividends from the mining sector. But, on the other hand, the oil sector, where both BP and Shell cut their dividends during the pandemic, that outlook looks much brighter now with the oil price where it is. It looks good for dividends. Interest rates generally are going up, it’s bad for the markets, bad for economically sensitive stocks.

Obviously, the cost-of-living crisis is affecting consumer stocks. So certainly, I wouldn't see huge dividend growth for that part of the market. But on the other hand, there are other areas which benefit from rising interest rates. Some banks benefit from it in the short term, at least as long as it doesn't bring the economy into recession, they benefit from rising interest rates. They can price their deposits better and it's better for their net interest margin. And insurance companies also to an extent benefit from rising interest rates. So, all in all, it's a complex picture, but I would see low single-digit dividend growth as achievable by the UK markets. I think we will get some dividend growth and the time that we are talking the dividend yield markets around 3.5 per cent. So, it's not a bad mixture at the moment, but it's obvious we're not going to get the kind of boom in dividends we've seen over the last 18 months.

Kyle Caldwell: And the prospect of a recession. How much of a concern do you think that is?

Job Curtis: Well, it is a concern. You know, a lot of companies are, to varying degrees, economically sensitive. And I think the issue is really that inflation has turned out to be much higher than people were expecting. Partly a reaction to the massive monetary stimulation, fiscal stimulation, we had during the pandemic, both in the UK and overseas, including the US. And now the central banks are all kind of reacting with raising interest rates. And it's very hard to fine-tune. I mean, they're determined to get inflation back down to the kind of 2% level, which is what most central banks have as targets and at the moment it is way above that and wages are picking up as well. So, you know, it's going to be very difficult for the central banks to kind of raise interest rates enough to tame inflation, but at the same time not tip the economy into recession.

I think there must be a good chance the economy does move into recession as a result. I mean, plenty of companies are cyclical, but it's worth saying that large parts of the stock market are less cyclical. And, you know, I'm thinking of, say, utilities; people have to carry on paying their water and electricity bills. I'm thinking of, say, pharmaceutical companies where healthcare spending, a lot of it, is funded by the government. And there are kind of more resilient sectors such as tobacco. There are sectors that, you know, benefit from rising interest rates, like banks and insurers. I think you could put the market in kind of one bucket. I mean, it's obviously that part of the inflation has been caused by the oil price and the oil companies are well placed short term. I wouldn't say it's a kind of negative across the whole market, but it's certainly not helpful for equities generally.

Kyle Caldwell: City of London has a very rich dividend heritage. Is the trust on track to deliver its 56th consecutive year of dividend increases this year?

Job Curtis: Yes, we've actually just announced our fourth interim dividend, it has just been declared. And we have made our 56th year of dividend increase. We've increased the dividend by 2.5% this year. I've been managing the trust for 31 years and in nine of those we've actually used revenue reserves to achieve the dividend growth. It's something investment trusts can do to build up a revenue reserve in the good years. You can hold back up to 15% of your income and use that reserve in the difficult years to grow your dividend. I think we've achieved it by mixture of having a core of quality companies that can consistently grow the dividend but also, you know, in the difficult times, we have been able to draw down on these revenues and then replenish them in the better years for dividends.

Kyle Caldwell: In the last financial year, did you need to dip into the reserves to fund that dividend?

Job Curtis: Yes, we haven't announced our results yet, for the year ending 30 June 2022. For the year ending June 2021, we did dip into the reserves. For this year, the board have made a statement to the stock exchange guiding that we are expecting not to use reserves and we're expecting to put money back into reserves for this year.

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Kyle Caldwell: Going forwards, how sustainable is the dividend? How strong are those revenue reserves?

Job Curtis: Well, I'm very positive about the companies we have in our portfolio. We're not over-dependent on any one sector. We've got a core of, in my opinion, very consistent companies that are quite global overall and some of them have got very good dividend records. We've got some interesting medium and smaller companies, but the core is large-cap consistent growers, not too heavily indebted. In terms of our revenue reserves per share, they account for around 40% of the annual cost of dividends. So, we have got a buffer zone there, which is good. But in addition, we have something called the distributable capital reserve, which in extremis we could use. We wouldn't expect to use it, but it's an ultimate backstop and that's basically the profits we've made over the years realised netting off any losses we've made and that accounts for about three times the annual cost dividends. So, we wouldn't want to use that, but it is the ultimate backstop, which we could use if necessary.

Kyle Caldwell: I also wanted to ask about investor sentiment towards the UK. It still seems to me to be quite poor overall. Even though, as we referred to the larger-cap companies in the FTSE 100, they've performed really well this year compared to other markets. Why do you think it is that investors are continuing to stay away from the UK, and what needs to happen for that sentiment to improve?

Job Curtis: Yes, I mean, I agree with you. The sentiment has been quite poor. I think it's partly because the UK is quite light in the sort of technology growth stocks, which everybody has favoured until recently. They've suffered a bit this year. And I think one of my competitors referred to the FTSE as being a 19th-century index, well, this year it's full of oil companies, banks, tobacco companies, that type of thing.  But that said, we've discovered that we do still need oil companies, banks are still good investments, and tobacco has done quite well. So, it's performed a lot better this year. But I think sentiment has been quite weak. I mean, globally, whatever we in this country felt about Brexit, I think it went down quite badly with global investors. And I think that didn't help with the referendum back in 2016. But, the UK has this very open system of corporate control. And I think the illustration of how cheap our market has been, is the number of takeovers we've had across the market, often from overseas companies or private equity groups.

In City of London's portfolio, over the last 18 months, we've had Morrisons, the supermarket, which was bid for by private equity interest. The Daily Mail was taken private by its kind of leading shareholder. And then we've also had Brewin Dolphin Holdings (LSE:BRW), which has been bid for by Royal Bank of Canada. These are all examples we've seen, but there are many more companies being bid for across the UK market. So, I think that just illustrates how cheap our market is. I'm a great fan of the UK market. We've got great companies, we've also got very high standards of corporate governance and a good dividend-paying pedigree. I'm very happy to be in the UK and it's good to see the UK performing better this year. We need to get some recognition.

Kyle Caldwell: And my final question, which we ask all fund managers we interview, do you have skin in the game?

Job Curtis: Yes, I do. I have a large holding in City of London, it's worth slightly over £1,000,000. I’m a great believer in it and I’ve definitely got skin in the game.

Kyle Caldwell: Job, thank you for joining us today.

Job Curtis: It’s a pleasure.

Kyle Caldwell: That's all we have time for, for today. You can check out the rest of our Insider Interview video series on our YouTube channel where you can like and subscribe. Hopefully, see you next time.