Don’t be fooled by the illusion of safety in income

Despite Covid-19 – or maybe because of it – investment trusts have had an excellent 2020, with strong out-performance of benchmark indices across many funds and on average.

However, there have been exceptions.

In particular, the UK income sector has suffered badly, with trusts such as Temple Bar, Lowland and Perpetual Income & Growth having a wretched time, the latter forced into a merger with the better-performing Murray Income (of which Merryn Somerset Webb, MoneyWeek editor-in-chief, is a non-executive director).

The cause? A collapse in dividends paid by UK companies.

So what might the future look like? And what can investors learn from this experience?

UK dividend income will take a long time to recover

In the second quarter, dividends paid by UK companies were cut by 57%. In all, 176 companies cancelling their dividends outright, and 30 reduced them. Just a quarter of dividend-paying constituents of the FTSE 350 maintained or increased payments.

For the year as a whole, a recovery is expected, but dividends paid by the FTSE 100 are forecast to be 32% lower than last year - £62bn vs £91bn. From there, growth is likely to resume, but a full recovery will take many years.

The sector has been struggling for years, largely as the result of exaggerated expectations in the first decade of the millennium. These expectations were based on sound logic.

Businesses that take capital from outside investors are expected to reward them out of their subsequent cashflow, to provide a return on capital that justifies the investment. This reward takes the form of dividends, hopefully increasing each year, while the investment at least retains its value.

Companies have also spent cash on share buy-backs, which should enhance the dividend potential of the remaining shares. Commentators regularly pointed out that re-invested dividends accounted for most of the long-term return of stock markets, while investors had been taught in childhood that “a bird in the hand is worth two in the bush.”

Dividends aren’t the be all and end all

Not to long-term investors, it isn’t. Companies with growth opportunities will want to invest their spare cashflow in expansion, either through capital investment or acquisitions.

It may be many years before they are ready to pay generous dividends to investors, by which point either growth prospects have diminished or the company is making the mistake of sacrificing growth for the short-term gratification of investors.

The wiser of those will take those dividends and reinvest them, not in the same company, but in companies with a strategy for growth.

Lulled by the snake-oil salesmen into believing that the short-term gratification of income insulated them from market volatility, investors crowded into income funds, particularly those managed by Neil Woodford at Invesco.

These fund flows pushed up the share prices of companies with high yields. This in turn encouraged managements to pay increasingly unsustainable dividends, often financed by debt, rather than pursue what seemed like a risky strategy of investment in growth and adaptation to a changing world.

The UK market came to be dominated by dinosaur companies with high yields but stagnating businesses, while income funds more or less held the same stocks.

This accounts for the relentless under-performance of the UK market. The Covid-19 crash turned a long retreat from that trend into a rout, with money flooding out of the UK income sector of the open-ended funds market – £436m in July alone.

Why investment trust income investors are at an advantage

As closed-end funds, investment trusts are immune from short-term capital flows and they have tools to sustain dividends that are not available to open-ended funds. In good years, they can retain a portion of their net income and then dip into reserves to maintain dividends in bad years for income, such as this, thereby reducing dividend volatility.

They can also sustain their income paying ability by capitalizing some of their major costs, such as management fees and interest, on the basis that these costs relate to growing the capital of the trust as well as to generating income.

In addition, they are able to pay dividends, in whole or in part, out of capital. This will sound imprudent to some but it allows a trust to pay a higher income to shareholders than could be financed from the portfolio.

The key advantage is that the manager can maximise total return (income plus capital) without being pushed into buying high yielders with their lower returns (the bird in the hand costs two in the bush).

JP Morgan Growth & Income have had particular success with this strategy, paying a yield of 3.7%, of which about 60% is financed out of capital. The total return of the trust is second only to Scottish American in the international income sector.

It will take seven years for a share bought on a 3% yield with dividends increasing at a rate of 10% a year, to yield more than a share yielding 6% with no increases. After 16 years, the accumulated dividends of the share bought on a 3% yield will have overtaken those on the 6% yielder. In the meantime, holders of the initial 3% yielder will enjoy significant capital gains, while holders of the 6% yielder will not.

It’s also more likely that the 6% yielder will have cut its dividend along the way or even gone bankrupt. In a world of zero interest rates, a 6% sustainable yield is simply too good to be true and unlikely to be sustainable. So it’s far better to invest in a portfolio of moderate yielders with the prospect of growth, or a trust that supplements its dividend from capital.

Alternatively, simply invest for growth and – with online dealing costs now so low – sell a few shares each year to generate an income. Another benefit of such a strategy is that it avoids a nasty income tax charge ten months on from the end of the tax year.

Investing in equities for income will enjoy a come-back – but it is likely to focus on international markets rather than the UK. Investment trusts have the flexibility, the independent governance and the resilience provided by fixed capital bases to satisfy continuing demand far better than open-ended funds.

Maybe some of those dinosaur companies in the UK will reinvent themselves and recover; if not, there will be plenty of opportunity for more dynamic companies to take their place.