Why investment trusts are a great place to look for income

Amid uncertainty over the security of individual UK company dividends, income-seeking investors are increasingly looking to make trusts part of their portfolios, says William Meadon.

Recently, investors reliant on dividends from UK equities have been dealt a blow, with dividend cut announcements from blue-chip companies such as Vodafone (a -40% cut) and Marks and Spencer (-25%).

In addition, there are other blue-chip stocks, for example, Centrica (9.5%) and BT (7.7%), where the seemingly high yields on offer may not be sustainable owing to the poor state of their finances.

Dividend growth from UK stocks is now so challenging that some analysts are predicting that there will be very little, if any, dividend growth from the UK stockmarket this year.

But, despite poor prospects for aggregate dividend growth, there is still good reason to be optimistic about the dividends being paid by some companies; it just means that investors must now be much more selective when choosing their investments.

One sector that we continue to find attractive is the UK housebuilding sector. Although the yields are high, the dividends are still well covered by earnings, which in turn are positively supported by wider industry trends.

For example, Persimmon and Barratt Developments, both of whom have significant net cash on their balance sheets and strong cash flows that allow them to pay their shareholders generous dividends.

Another example is Legal & General, the life assurer, which has for many years focused on simplifying its business to generate greater cash flows for shareholders. The reward has been growth of some 15% per annum in the company’s dividend payments over the past decade.  

Tobacco stocks are completely unloved at the moment, as the trend against smoking in developed economies continues apace. However, Imperial Brands has a significant proportion of its sales coming from emerging markets, where smoking rates are still relatively high and where cigarette sales are more lightly regulated. This has given the company sufficient confidence to say that it can grow its dividend by 10% this year and announce a buyback. If so, the shares currently offering a 10% yield, look anomalously cheap.

Mining giant Rio Tinto has become highly cash generative after the collapse of the commodity super-cycle in 2015, which has forced some introspection on shareholder value and capital allocation. Subsequently, the iron ore miner has refocused from volume to value created. This change in strategy included increased payments to shareholders through both dividends and buybacks.

This year, Rio Tinto has benefited from the iron ore price rising more than 60%. They have also supplemented their regular dividend with a special dividend, which was funded through a disposal of the last of their coal assets and their stake in Indonesian copper mine Grasberg. 

With such current uncertainty over the security of individual UK company dividends, it is understandable that income-seeking investors are increasingly looking to investment trusts to form part of their portfolios.

Investment trusts are publicly listed companies that trade very similarly to any other, except that they are designed solely to deliver investment returns to their investors. One of the many benefits of investment trusts is that they can offer investors a degree of income protection.

Their unique structure means that in good times, they are able to retain up to 15% of their gross annual income, to create a reserve fund that can be drawn on to pay dividends when market conditions become tougher. This gives much greater security over the dividends they pay to their shareholders. JP Morgan Claverhouse, for example, has more than one year’s worth of dividends tucked away in reserves.

William Meadon is investment manager of the JPMorgan Claverhouse investment trust.

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