Why UK dividend cuts may be a good thing
The UK equity market has seen a plethora of dividend cuts and rights issues in the wake of the...
The first investment company was launched some 150-odd years ago in 1868. From the very beginning, they were pioneers, seeking investment ideas from around the globe – even in the emerging markets of their time: Cuba, Brazil and USA, for example!
And having survived a number of world wars and stock market crashes, their longevity is impressive: today there are some 400 different investment trusts on offer, still financing infrastructure around the world and finding innovative business opportunities.
There are a few steps investors should go through when considering an investment in a trust:
At FundCalibre, we like managers – whatever type of fund they run – to have long track records. It means they have experience of investing throughout all the different stages of a stock market and economic cycle. The longer their track record, the better we can analyse the value they add, with our proprietary screening tool, AlphaQuest: it measures the consistency of returns a manager produces, to see if they are truly skilled or have just been lucky.
Happily, many managers stick with investment trusts for a long time – more than half of investment companies have had the same fund manager at their helm for more than a decade*, while almost a quarter (23%*) have had at least one of their managers in charge for 20 years or more.
Because an investment trust has a limited number of shares, the price of its shares is affected not only by the performance of the underlying investments, but by investor sentiment towards the trusts itself: like other things in life, the more popular it is the more expensive it becomes and vice versa.
If a trust is seen as being desirable, its share price may rise to a premium over its net asset value (NAV) – in other words, the shares are worth more than the value of its underlying assets. If it is not so appealing, its share price may fall to a discount.
This means you are sometimes paying a bit more for a share in trust, or could be getting a ‘bargain’.
But it is important to think about why a trust is trading at a premium or discount. For example, is a discount a function of short-term negative sentiment, or has the market identified a fundamental flaw with the investment strategy or fund manager? Does the trust usually trade at a discount or premium and if so, how far from the norm is it currently trading?
So you need to look at a trust’s historic pricing to understand whether or not it is offering good value or not.
Another key element of an investment trust is gearing. This is the mechanism by which an investment trust borrows money in order to make extra investments, with the aim of achieving a return greater than the cost of the borrowing.
For example, take an investment trust with a value of £100 million. If the stock market is rising, the fund manager may see lots of potential opportunities. But to take maximum advantage, he or she might want to invest an extra £20 million. Having borrowed the money to do this, the investment trust is now ‘20% geared’.
In the right hands and right market conditions, having the flexibility to allocate more capital to favoured assets can pay off. When the market gathers momentum, the investment trust gets an extra boost.
In 2012, for example, when Shinzo Abe became prime minister of Japan, the Japanese stock market was looking cheap. Abe’s reforms (later coined ‘Abenomics’) were full of promise to finally lift the Japanese economy out of a deflationary environment. Investors who had conviction that, after many years of false dawns, the reforms would have the desired effect, could have invested in a Japanese equity trust, like Baillie Gifford Japan Trust, to take advantage of its gearing, and been highly rewarded: while the average open-ended Japanese equity fund returned 130.23%** from 5 December 2012 to 1 October 2018, the average Japanese equity investment trust returned 232.74%**. Baillie Gifford Japan Trust, which is Elite Rated by FundCalibre, returned 331.58%**.
However, much will come down to the fund manager’s skill and getting the call right. Because on the flip side, gearing can also exacerbate losses and volatility during times of market stress.
So investors should look at how much gearing is possible in an individual trust, how much the manager tends to use, and how they use it. This will differ from trust to trust. Investors need to be comfortable with the level of gearing, as it can increase the risk significantly.
Saving for a rainy day is an idiom we all know well. Investment trusts can do this too, via a ‘revenue reserve’.
When an economy is strong, dividends payments from companies can be a great source of regular income for investors, but how reliable they are can be anyone’s guess. As we have seen in the past, companies can cut their dividend payments or stop them altogether if times are bad and they don’t have the spare cash to return to their shareholders.
During the good times, investment trusts can retain up to 15% of the dividends they receive in a pot called the revenue reserve. The better the dividends the fund manager gets, the more money can be put aside for the future.
During the bad times, when dividends become more scarce, the fund manager can tap into the reserve and boost lacklustre dividends for a more steady return.
This stability of income can be especially attractive to investors who need a consistent income – perhaps those using the income from their investments to help pay monthly bills, for example.
One of the best trusts in terms of its dividend-paying record, is City of London Investment Trust. Launched in 1891 it has increased its dividend each year since 1967. It has been managed by Job Curtis from Janus Henderson since 1991 and, during that time, Job has dipped into his revenue reserve on seven occasions to maintain its income-paying track record.
Last, but by no means least, accountability is becoming increasingly important to investors. Having an independent board is one way of ensuring this accountability.
An independent board is made up of a group of experienced professionals that support the fund manager in delivering his or her ideas. They have the acumen to spot if the fund manager is going off track and the authority to question how performance may be improved. They also act as a fair and objective earpiece for investors.
The quality of the board will depend on the quality of its members. So we would also suggest that investors examine the track record of an investment trust’s board. How active have they been in looking after shareholders’ interests? Is there a discount control mechanism in place? Are they willing to issue shares when demand is high to avoid the investment trust moving to a high premium and to buy shares when demand is low and a discount has got too wide?
There is a lot to consider when choosing an investment trust but, with the right guidance, it is possible and the outcome can be very rewarding.
*Source: The Association of Investment Companies, 19 June 2018.
**Source: FE Analytics, total returns in sterling, for the IA Japan sector, IT Japan sector and Baillie Gifford Japan Trust, 5 December 2012 to 1 October 2018.