Saving investment income for a rainy day

Dividend growth from UK companies has been strong over the past decade and, at the moment, the UK stock market yields around 4.5% – almost 50% more than the MSCI World index. That makes it very attractive for income-seeking investors, but is that yield sustainable?

Leaner years ahead?

As Scott McKenzie, an equity income fund manager at Saracen, pointed out to us earlier this week: there is an unhealthy concentration of dividends in the UK. Last year, 15 ‘megacaps’ accounted for 56% of all UK dividend income. Many of these companies are among the UK’s largest and are in sectors such as oil, mining and pharmaceuticals – sectors that have been given a life-line by the falling pound. This makes Scott wary: if the pound were to bounce back, these dividends would fall in sterling terms. It’s why he prefers smaller and medium-sized companies in the long run.

David Coombs, manager of Rathbone Strategic Growth Portfolio agrees there are risks. He recently pointed to issues such as Brexit, a slowing economy and evolving consumer trends as reasons some companies – like Vodafone and Marks & Spencer – are deciding to sacrifice high dividends in favour of investing more in their businesses.

He said: “There is massive disruption going on in many sectors across economies driven by technological changes, consumer changes and political changes. There will be more dividend cuts this year.” He is far from alone in thinking that we could have leaner year ahead in terms of dividend payments.

Rainy day dividends

As investment trusts are listed companies in their own right, they can store future income for a rainy day. And, during periods of uncertainty like those we face today, these ‘revenue reserves’ (as they are called) can be a comfort for income investors.

Revenue reserves enable investment trusts to continue to grow their dividends even when dividends across the stock market are falling. This is because they do not have to distribute all of their income every financial year and can hold some back (up to 15%) for leaner times. For example, in a good year, an investment trust could pay out 95% of its income and keep 5% back. Over time this can build to a substantial sum held in reserve.

The largest revenue reserves tend to be found in old investment trusts which have accumulated over many years. The only caveat is that revenue reserves are finite, so using them to sustain dividend growth can only take place for a number of years.

City of London: a dividend hero

A great example of revenue reserve use comes from City of London Investment Trust. Managed by Job Curtis for the past 27 years, the dividend has grown every year. Job has dipped into the revenue reserve on seven different occasions in that time.

Job remembers one run of occasions: “I aim to be invested in companies that can consistently grow their profits and dividends through the cycle. However, during economic turn downs there are bound to be companies that disappoint.

“Our financial year ends on 30 June and I can well remember how difficult is was for world equity markets over the 12 months to 30 June 2002 [the UK stock market fell almost 15%* and the global stock market fell almost 22%*]. Yet we were still able to increase the dividend per share by dipping into the revenue reserve. It was after three years of using the revenue reserve that it could once again be added to, rather than used.”

City of London investment trust has in fact increased its dividend each year for the past 53 years** (with earlier rises under another manager). Elite Rated BMO Global Smaller Companies is another dividend hero, along Scottish Mortgage Investment Trust, having raised their dividends for 48 and 36 consecutive years, respectively**.

*Source: FE Analytics, total returns in sterling for the FTSE All Share and MSCI World index, 1 July 2001 to 30 June 2002.
**Source: The Association of Investment Companies, 12 March 2019.

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.