It is easy to see the attraction of the City of London Investment Trust (CTY) to those seeking income. Most obviously, the dividend growth record here is clearly very impressive. The trust is a member of the AIC Dividend Heroes, which signifies at least 20 years of consecutive annual dividend increases. Its actual record is much better. The last time it failed to increase its payout was when England won the World Cup – so nearly 55 years and counting.
The ongoing low interest rate environment amplifies this point even more. I mean, City of London shares offered up a dividend yield of around 4.5% ten years ago. It has increased its payout at a circa 4.2% per annum clip in the years since. The appeal of that to yield hungry investors is clear to see – and perhaps even more so given the mandate is in UK blue chip stocks.
Portfolio
On that note, let’s take a quick look at the portfolio here. Top holdings show that consumer stalwarts British American Tobacco, Diageo and Unilever occupy the first three spots. FTSE 100 members make up the vast majority of assets, though some quality overseas names like Coca-Cola, Nestlé, Johnson & Johnson and Microsoft also feature. Those four made up a £70m block at last count, or 4% of the portfolio. The top-ten account for around 30% of the holdings, while the portfolio contains around 85 names in total.
One other thing to like – the ongoing charge looks very reasonable. It stood at just 0.36% last year, down from 0.46% ten years ago. Suffice to say that is pretty competitive for an actively managed fund. Its size probably helps in that respect – net assets (“NAV”) clock in at the £1.5b mark – but the point stands nonetheless. Total returns here have also outperformed the broader UK market by almost a point per annum since 1966, which is more impressive than it may look.
Revenue Reserves
Now, the issue of revenue reserves crops a lot in financial media. As an investment trust, the company has to pay out the vast majority of its income to shareholders. I believe it can legally retain up to 15%, which ends up in the ‘revenue reserve’ line on its balance sheet. This amounted to just over £45m at the end of the company’s fiscal 2020.
Occasionally, you see that line referred to as a discrete pot of cash which can supplement the dividend in lean years. Commentary from management teams can also raise connotations of a rainy day fund, perhaps to appeal to conservative-minded income investors. To be clear, this is not misleading, but the revenue reserve is perhaps more akin to the ‘retained earnings’ line of a normal corporation. Temporary shortfalls in the dividend will come out of NAV, but it doesn’t matter too much. As long as UK-listed equity offers a long-term rising stream of income, the minutiae of smoothing things out for shareholders isn’t very important.
COVID
Of course, equities are anything but smooth on a year-to-year basis. 2020 and the COVID pandemic provide the best proof of that – the UK clearly taking a big hit. BP and Royal Dutch Shell spectacularly slashed their payouts due to the slump in oil prices and downstream conditions. Further, the FTSE 100 contains its share of banks, with those barred from paying dividends by the Bank of England. That caused uproar in some cases – HSBC’s investors in Hong Kong were not too happy – but the economic carnage means that bank dividends were always going to be in the line of fire. Overall, tens of billions in lost dividends hit shareholders of UK equities.
Clearly, City of London’s own dividend was never going to be immune from that. Net revenue return – mostly dividends from its equity investments, less management fees, taxes and so on – came in at £62.5m last year. That was down on the £72m recorded in the previous year. On a per-share basis, net revenue return clocked in at 15.7p, down 20% on FY19. This is clearly a bit out of date now – City of London’s fiscal year ends in June, while many UK firms returned to paying dividends in the second half of 2020. Still, last year’s 19p per share dividend had to be covered partially by revenue reserves, and we can expect the same this year too.
After that, some question marks remain. The trust can dip into capital reserves to keep the dividend record going, but let’s avoid that debate. Unilever just bumped its quarterly payout 4%, which will help as the third largest position here. The banks – City of London’s stake in HSBC and Lloyds was worth £57m at last count – will return to dividend-paying status by its fiscal 2022, if not sooner. The foreign holdings – particularly its American ones, but Nestlé too – are very reliable dividend raisers. Let’s wait and see.
Balance Sheet
A quick word on the balance sheet. Obviously one of the characteristics that defines closed-end investment companies is their ability to take on debt. Total borrowings here stood at around £135m at the end of FY20. Call that a gearing level of circa 9% based on the NAV figure above.
Now, notes attached to the trust’s financial statements reveal that £30m of that debt was in the form of a rather expensive 8.5% debenture. That was due to expire in January, and a quick look at the company’s announcements reveals it was duly redeemed. It also redeemed a £10m 10.5% debenture late last fiscal year. Finance costs should therefore reduce accordingly going forward. Long-term debt – circa £85m at the end of FY20 – constituted around 6% of net assets and attracts interest at the much lower blended rate of around 3.6%. It also has a £120m credit facility with HSBC, of which around £21m was drawn at the end of FY20. That attracts interest at 125 basis points above the base rate.
Valuation
The shares closed the day at 356.5p each. That puts the dividend yield here at circa 5.3% based on an annualised payout of 19p per share. The current share price also represents a small premium to NAV. It remains down 17% on pre-COVID levels.
The past few years has seen City of London underperform its benchmark. Growth outperforming value more generally during that time probably explains most of this. On a ten-year view, City of London has outperformed – with a total return of 96% compared to 72% for the FTSE All-Share Index – and the ultra-long-term performance mentioned in the opening section speaks for itself. That may help explain the small premium to NAV too.
Looking ahead, the company seems reasonably priced for conservative investors. The very near-term obviously hinges on COVID. Many of its holdings remain bruised, and dividends seem unlikely to be covered by revenue return this year. On the flip side, ultra-low interest rates continue to support the investment case. Longer-term, it seems to me that the trust doesn’t require too much by way of growth to do well. Anything resembling the last couple of decades – that is, mid-single-digits per annum – would be fine when tacked onto a base yield in excess of 5%. In the ‘lower for longer’ interest rate environment, implied high single-digit returns looks like an okay deal.
Note
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