A guide to the City of London Investment Trust

Ask any English sports fan about 1966 and they will immediately tell you it was the last time “football came home”, with Geoff Hurst completing his hat trick in England’s 4-2 World Cup final win over West Germany. It was then that BBC commentator Kenneth Wolstenholme uttered his famous line: “Some people are on the pitch, they think it’s all over. It is now!”

A vintage year for the England men’s football team has been followed by 58 years of hurt. By contrast, it was also the start of the City of London Investment Trust’s (CTY) dividend growth record,

which has continued to rise – across many different economic environments – to this day. To put that into context, a £1,000 investment in CTY would have yielded investors £50,500 in gross income since (assuming they had not reinvested this income) – this compares to just £3,900 from a savings account over the same period; and £34,200 paid out by the UK equity market*.

CTY aims to provide growth in income and capital by investing predominantly in larger UK companies with international exposure. It is a conservative portfolio of 80-90 holdings, with a diversified spread of sector positions and not over concentrated stock weightings. CTY has been managed by Job Curtis since 1991 and has an excellent long-term track record, which we will discuss further in the performance section.

Valuation driven but macro aware; with valuation central to the stock selection process

Job focuses on companies that can pay and increase their dividends over time. He pays close attention to valuations and is careful not to overpay when he initiates positions. Currently, he particularly likes companies in the financial sectors (banks and insurers) and also favoured multinational brands with stable earnings and growth prospects. He has a bias towards large-caps, with 60% of the portfolio typically held in companies that sit in the FTSE 100.

Job aims to provide shareholders with dividends between 10% and 30% higher than the average for the UK equity market. Dividends are distributed quarterly.

The process is based around valuation-driven stock selection, but taking notice of macro factors. Dividend yield is the most important factor behind the process, but other measures of share price valuation are considered. At its heart, CTY has a conservative approach with cash generation supporting both dividends and capital expenditure. Job likes strong balance sheets, particularly for cyclical companies – as it builds an element of resilience in challenging periods – as part of the wider theme of seeking a “margin of safety” in the underlying holdings.

The trust tends to target companies with a yield of at least 2% (with the portfolio biased towards stocks with above average dividend yields), and also has a revenue reserve to support the payment of dividends. CTY has recently announced a reduction in the investment management fee to 0.3% of net assets – the ongoing charges stand at 0.37%, the lowest in the AIC UK Equity Income sector**.

Why now for this portfolio

• CTY has an excellent track record since Job took over in 1991. In addition to an attractive dividend yield (currently 4.74%)** and a 58-year track record of dividend increases (currently 20.6p per share), Job has returned 1,462% to investors, well ahead of the 1,115% garnered from the FTSE All Share Total Return***.
• At 31 August 2024, CTY’s portfolio P/E was 10.7x compared with 11.7x for the FTSE All Share Index, which is well below its long-term average – indicating an attractive entry point.
• UK equities are beginning to attract greater attention, with M&A on the rise and an increased number of share buybacks (an indicator of companies seeing value in their own shares).
• Investors being “paid to wait” (see manager’s view section) – despite UK equities appearing undervalued, dividends are not only attractive, but more sustainable following the “dividend reset” during the Covid pandemic in 2020.
• Attractive low cost long-term fixed rate debt gives CTY freedom to use gearing in a higher rate environment (it should be noted gearing can also exacerbate losses as well as gains).
• Revenue reserve has been built up again following Covid.
• Attractive ongoing charge of 0.37%.

Manager’s View

“You are being paid to wait. You can receive an attractive dividend flow with possible capital appreciation as profits grow and scope for valuation rerating.”

Job Curtis believes a conservative portfolio of this nature is well-positioned to take advantage of any turnaround in the fortunes of UK equities. But importantly, while the market is still challenged, you are still getting any attractive dividend yield (currently 4.74%) on the portfolio.

Dividend growth is an integral part of investing; as mentioned earlier, an investment of £1,000 in CTY in 1966 has yielded investors £50,500 in gross income*. Importantly, Job believes dividends are now more sustainable – a stark contrast to the pre-pandemic environment where the market was on a decent yield but companies were over distributing.

Job points to two other key indicators that UK equities are becoming more attractive. The first is takeovers, with M&A activity on the rise in the UK in 2024. Two of the top five stock contributors in the last financial year were logistics and supply chain company Wincanton, and Round Hill Music, both of which were acquired in that period. Figures from PwC indicate that the value of M&A sales in the first half of 2024 rose by two thirds year-to-year (£68bn vs. £41bn in H1 2023)****.

The second indicator is that the number of share buybacks continued to remain at elevated levels – an indicator that companies see their own businesses as cheap and therefore an investment opportunity. CTY is no exception – the trust bought back 8.3 million shares in the year to 30 June 2024 at a discount of 2-3% to NAV, which contrasts nicely with the 218 million new shares issued (at a premium to NAV) over the past decade, increasing share capital by 76%***.

Job says this is also a reflection of the CTY board’s willingness to keep the trust close to its NAV. This has been reflected by CTY currently operating at a 1.85% discount, which might be an attractive entry point given it has traded at an average premium of 1.9% over the past five years**.

Job also believes the UK market is operated on a near 20% discount to its global peers on a like-for-like basis. A good example of this is British American Tobacco (BATs) or Imperial Brands which are trading on P/Es of 7.5x and 7.6x respectively, well below the likes of Philip Morris (19x)^.

He says: “BATs and Imperial are offering attractive yields of 8.5% and 6.8% respectively, a healthy difference with Philip Morris (4.4%). There are reasons why Philip Morris should be on a higher rating, but the dispersion is simply too great – sentiment is playing a big role.”^

The result is a portfolio which has seen its overseas allocation cut from 15% to 10% (see portfolio activity section). It should be that CTY invests in large companies, many of which have a global footprint, with roughly 64% of the portfolio’s revenue exposure coming from overseas**. The maths does not make sense – global companies with overseas revenues but tarred with a UK valuation – this is an opportunity.

CTY’s small and mid-cap exposure has also risen to 12%. Both segments have slightly outperformed large-caps (FTSE 100) in recent times, partially as a result of the increased number of takeovers in this market.

UK hopes tempered by global concerns

Gearing remains relatively low (5%), despite CTY’s board locking in attractive debt facilities in the lower interest rate environment. Job says part of the rationale for this caution is his ongoing concerns over global markets.

He says: “Aspects of the global economy continue to worry me – as do the size and possibly valuations of some of the big US tech stocks.. The market capitalisations of Apple, Microsoft and NVIDIA are each worth around all of the FTSE 100 – their valuations could be vulnerable if they disappoint investors’ expectations. The UK offers relative value but would, of course, be adversely affected by falling global equities. Geopolitical tensions are also a worry – there is war in the Ukraine and the Middle-East, and rising geopolitical tensions in China.

“I’m also not as optimistic on UK inflation – core inflation is still sticky at 3.6%, especially in the services sector, and we are seeing generous public sector wage increases without the increases in productivity to support them. UK interest rates are on a downward path – but perhaps not as fast as some expect.”

Portfolio activity

The three largest contributors to stock performance in the last financial year were 3i, an investor in private companies, defence company BAE Systems and NatWest Bank***. 3i benefitted from strong growth of its investment in Action, a discount retailer in Europe, while BAE’s growth was linked to increased demand for equipment amid rising external threats.

NatWest recorded profits above market expectations – it was a position Job doubled in the portfolio in early 2024 and is part of a wider move from underweight to overweight the banking sector for the first time in 20 years (it is the largest sector weighting at 11% of the portfolio)***.

Job points to good profits and dividends expectations as the banking sector continues to benefit from the higher rates not seen since the end of the Global Financial Crisis in 2009.

He says: “UK banks are quite cautious – they hedge out interest rates every year. This means they have these hedges over 5-7 years, so every year certain hedges are coming up to maturity. Some are now maturing on much lower interest rates and the banks will be able to reset them at much higher interest rates. This is a strong tailwind for the sector.

“Dividend growth has been good for the sector, but we think there is more to come. NatWest’s pay-out ratio is only 40% of its earnings and dividends. We think it could easily be up to 60-70%.”

By contrast, the biggest detractor was not owning Rolls Royce, a strong performer which does not pay a dividend, which makes it challenging for the portfolio to hold to any meaningful degree.

Turnover has roughly been 10% across the portfolio. One of the themes for this has been the move to bring overseas listings down from 15-10%. Examples include French telecommunication company Orange being switched to BT. Job says the French market is very competitive with four main operators – by contrast BT is rolling out Full Fibre aggressively and aims to conclude this process by 2027***. This will create a greater free cashflow and save costs from switching off lines (not to mention the copper that becomes available from switch off). It currently has a yield of 5.5%.

The team also sold French pharmaceutical company Sanofi and added to existing positions in AstraZeneca and GlaxoSmithKline***.

Further additions included Aviva – which Job says has had a chequered time over the past 20 years, with two dividend cuts, but a much stronger business has emerged. It is the leading general insurance operator in the UK and number two in Canada. He says: “Both are strong businesses benefitting from rate increases and inflation subsiding. Both have good life insurance businesses throwing off cash and are also growing in healthcare and pensions. Valuations are attractive as is the 6% dividend yield.”

Another is Inchcape, which is now focused on auto distribution. Job says they have long standing relationships with the major car manufacturers (going back 30-40 years). Inchcape helps them in emerging countries to move cars from ports to showrooms, as well as marketing and spare parts. With a PE of 11x and a dividend yield of 4.4% – it is also buying back shares. Job says: “It is on a discount of 20% to what it has been in the past and it is now a better cash generative and capital-light business.”

Performance

CTY has an excellent track record since Job took over in 1991. In addition to an attractive dividend yield (currently 4.74%)** and 58-year track record of dividend increases, Job has returned 1,462% to investors, well ahead of the 1,115% garnered from the FTSE All Share Total Return (347% outperformance)***. A reflection of the ability to provide capital and income growth.

Over the past five years, CTY has produced a NAV total return of 39.8%, slightly ahead of the AIC UK Equity Income sector (37%), while from a share price total return CTY stands at 32.9% (vs. 32.6% for the sector)**. Stock selection has been a principal driver of returns, with Job looking to spread risk across this conservative portfolio.

There will be points where decisions can lead to underperformance. For example, the trust was underweight banks and energy in 2023, which saw stock selection account for a 4.32% loss in performance attribution***. Ultimately, stock selection has been a positive contributor to performance in seven of the past 11 years of the trust, indicating a successful long-term investment philosophy^.

Est. Performance Attribution (Relative to FTSE All-Share Index)

As we have discussed, the dividend yield is also a big attraction. This year saw it increase for the 58th consecutive year and it was fully covered by earnings per share. Job is happy to mix higher yielding companies with lower yielders to generate growth. For example, he currently holds the likes of RELX, which yields around 2% and is on a 28x P/E, as well as the likes of 3i and AstraZeneca (which also yield around the 2% mark). He balances this out with higher yields, like the aforementioned tobacco companies.

What else do investors need to know?

Good spot for gearing and revenue reserve revival

Gearing has also contributed to performance in the past financial year of the trust (+0.25%). CTY is well positioned here by securing cheap rates of borrowing using secured notes. These include £35m at 4.53% for 2029; £30m at 2.67% for 2046; and £50m at 2.94% for 2049. Despite this, gearing remains at a low level (5%) amid concerns about the wider global economy**.

The trust is also allowed to retain some of its surplus income and create a revenue reserve to pay out to investors in leaner times. The reserve was used during Covid, transferring 21% in 2020 and a further 12% in 2021 amid the huge swathe of income cuts in the market***. However, it has since recovered from this challenging period. In the past financial year, the reserve increased by £2.3m to £46.6m, with revenue reserves per share increasing by 5.8% to 9.43p. The capital reserve from capital gains on investments sold can also help fund future payments – this also rose by £1.7m in the past financial year to £346.3m*.

Outlook

A conservative building block ready to tap into the turnaround in UK equities

Manager Job Curtis has experienced many different conditions in his 33-year tenure as manager of this trust. However, to continue to deliver a rising dividend per share during the challenging times of the pandemic in 2020-2021 is testament to the philosophy of this investment portfolio. If it can manage a challenging period like that it is robust enough to manage almost anything.

The swathes of cuts across the industry was arguably the biggest test a portfolio like this could face, yet it has come through with flying colours. Now it is in a strong position to tap into the growing opportunities in the UK markets. The portfolio is cheap versus its own recent history and is tapping into a revitalised income market, coupled with a host of companies on discounts simply because they are listed in the UK.

Valuations across the market now look attractive and CTY’s focus on valuation metrics, strong balance sheets and resilience should stand it in good stead if the recent M&A activity and buybacks is just the start of a prolonged recovery in UK equities. In the meantime, investors are getting an attractive dividend yield as they wait for this to come to fruition.

If investors want a cost-effective, well-diversified portfolio of robust income-generating, UK business then this would be a strong consideration.

*Source: City of London Annual Report 2024, 30 June 2024
**Source: Association of Investment Companies, 22 October 2024
***Source: City of London Investment Trust Update, September 2024
****Source: PWC, 25 July 2024
^Source: Janus Henderson Investors, 2013-2024