Mary Sullivan explains how some investment trusts manage to pay out steadily rising levels of income year after year.

As interest rates on cash savings are slashed yet again, cutting to rock bottom the income that many investors rely on to supplement their pensions, and reducing the increases in other savers’ nest-eggs to close to zero, many investors in investment trusts are sitting pretty.

Instead of seeing their income fluctuate wildly in recent years in line with interest rates, they have seen it increase steadily. And even now, despite the current turmoil on the world’s stock exchanges, the upward trend in investment trust incomes is expected to continue.

Almost a quarter of conventional investment trusts that are more than 20 years old have paid consistently increasing dividends throughout this period. Some have managed this feat for longer – for 30 or even 40 years. And their boards say they have no intention of stopping now, which is naturally good news for investors.

However, providing the companies are themselves sound they will go on paying out a steady flow of dividends to shareholders. Companies recognise the importance of rewarding their ‘owners’ in this way, and the difference that dividends make to investors’ returns cannot be understated.

For this reason, it is also a key aim of many investment trusts – including those without an explicit income objective – to provide investors with a dividend that grows over time and, wherever possible, keeps pace with inflation.

Building up over time
The role that dividends play in investment returns is highlighted regularly by Barclays Capital’s Equity Gilt Study, which compares the returns on various assets over more than a century. Its 2009 study shows that £100 invested in equities at the end of 1899 would now be worth just £139 in real terms without the reinvestment of dividends,
while with reinvestment the portfolio would have grown to an impressive £17,571.

This shows how crucial dividends are, not only for investors seeking income but for everyone building up their capital. But this is not to say that dividends do not fluctuate.

Although they have grown by an average of 7.8 per cent per annum over the past five years, some companies have been announcing cuts recently, or even cancelling dividend payments completely. Naturally, this will impact on the investment trusts who hold these shares in their portfolios. However, some have a secret weapon with which to combat the downward trend in dividends – reserves.

Simon Elliott, head of investment trust research at stockbroker WINS, explains: ‘Investment trust boards don’t have to pay out to shareholders all the dividend income they receive each year, unlike unit trusts or OEICs. They can retain up to 20 per cent and place it in reserve, so in the good years they can keep some of their income back which they can then use to smooth out payments when times are tough.’

Decades of rising dividends
This facility has helped some trusts to pay out steadily rising dividends for years (see the table below). The trust with the longest record of dividend increases is City of London, which has paid out a higher dividend every year for the past 42 years. It is closely followed by Alliance Trust, Bankers and Caledonia Investments, which have 41-year records of consecutive dividend increases.

Different types of trusts have achieved these long service medals for income increases. Not unexpectedly, in the UK Growth & Income sector, 45 per cent of trusts with 20-year track records have increased their dividend annually for at least 20 years. But the diversified trusts in the Global Growth sector have been equally diligent on behalf of their investors, with nearly half (48 per cent) of those that have been around for 20 years increasing their dividends every year over that period.

Can it continue?
The crucial question for investors now is whether trusts will be able to keep up their unbroken records when experts are forecasting ongoing cuts in UK dividends of 15 per cent this year and up to 20 or 30 per cent across the cycle.

The UK market is also heavily reliant on the fortunes of a few companies such as AstraZeneca, BP, GlaxoSmithKline, HSBC, Shell and Vodafone. With expected dividends of £69 billion for the market as a whole in 2009, these six large dividend payers account for nearly half of all these anticipated payouts.   

Charles Luke, co-manager of Murray Income trust, which has a 25-year run of increasing dividends, admits ‘Circumstances are extremely difficult this year with many companies, such as Anglo American, cutting back or even scrapping dividends altogether. Most of these companies have good reasons for doing so, such as having debt that needs to be repaid, but it doesn’t make our job any easier. Even companies that appear to have the most secure dividend streams are not immune from current economic problems.’

He says the strategy of Murray Income is to focus on good-quality companies ‘in control of their own destiny and not reliant on any one particular economic scenario’, so he hopes they will be able to continue paying their dividends. However, if not, Murray Income has income reserves in its coffers equivalent to over one and half times its current annual dividend, which means it would still be able to maintain its income payments to investors for at least one and a half years even if it received no dividends on its holdings at all for that period.

Topping-up the yield
In practice, trusts would only need to dip into their reserves from time to time as not all companies will stop paying dividends completely. They can be used for top-ups. And for some of these trusts, even that is unusual. Alex Crooke, manager of Bankers, a global growth trust with a 41-year history of rising dividends payments, points out that only once during that period has the trust actually paid more out in dividends in a year than it received.

However, he admits, ‘We may be getting back to those times, but fortunately, over the past six years we have squirrelled away £30 million as company payouts have risen. Last year, for example, we paid out £12 million in dividends but we also put £2.5 million into our reserves.’

However, Crooke says he will be doing his best to maintain the trust’s dividend inflows. His value approach favours companies that generate cash. ‘I don’t necessarily invest in companies paying the highest dividends but I do like every stock to contribute.’

He says this approach can be a good investment discipline. ‘For example, seven or eight years ago, when the boom started, we invested in the mining sector because companies were paying nice fat dividends, but two or three years ago they decided things were so good they had better reinvest their profits rather than pay out dividends. For us, this was a sell signal and we dramatically reduced our exposure. It was about six to nine months too early but it was still good timing.’

He doesn’t always sell a company that cuts its dividends. A good example is pub group JD Wetherspoon, which decided in January to axe its dividend so that it could repay a £100 million loan out of its cash flow. ‘We were a bit upset about it but we can see that it will actually make the business stronger in the long run,’ says Crooke.

Focusing on resilience
There are certain sectors where companies’ dividends are expected to remain strong
even when the economy is struggling, and investment managers have been adjusting their portfolios accordingly over recent months. Karen Robertson, manager of Standard Life Equity Income Trust, says, ‘Sectors where we believe dividends will remain rock solid are utilities, tobacco, pharmaceuticals and telecoms. There are also odd little stocks, which have so far been ignored by the market but which are performing well, such as Provident Financial, which deals in home collected credit, and De La Rue, the world’s leading printer of banknotes.’

No one doubts, however, that it will be more challenging for managers to maintain income flows into their portfolios while the recession continues. So which of the long-standing income payers would experts regard as likely to produce the best returns going forward?

Simon Elliott of WINS cautions that it is important that managers do not let the dividend tail wag the investment dog. A trust that he likes, whose managers are not ‘income junkies’, but still has one of the longest pedigrees for increasing its income, is Alliance Trust. ‘Its performance was dull for some time but it has improved and I don’t think it will struggle to maintain its dividends. I also think Bankers, with its value approach, is well suited to where we are in the cycle.’

Daniel Lockyer of iimia, who manages an income fund that invests in investment trusts, also warns that having to raise dividends every year can end up as rather a millstone round a manager’s neck. The problem is that ‘They end up focusing on dividend and losing sight of the rest of their investment objective.’  That said, trusts that Lockyer believes don’t fall into that trap include Alliance, British Empire Securities, Scottish American and Lowland.

For investors uncertain about where to put their savings at present, such long-established investment trusts – which have shown their ability to weather storms in the past and have the added advantage of a treasure chest of income reserves – are looking increasingly attractive for investors who are seeking total returns as well as income.