City of London

City of London (CTY)’s objective is to provide long-term growth in income and capital. The broader objective includes a reference to the “importance of dividend income to shareholders”, which cuts to the heart of CTY’s mission: an unrivalled 52-year record of increasing dividends paid to shareholders in consecutive years.

Within the UK mandate, there is a degree of flexibility to invest outside UK equities. Job Curtis has had sole charge of CTY since 1991, and over the ensuing 28 or so years, has demonstrated opportunistic adventures into fixed interest, convertibles and equities listed on other exchanges around the world in order to boost the yield, or add an exposure otherwise lacking in the FTSE All Share.

In Job’s view, the UK has much to attract investors: good yields, a dividend paying culture and a wide range of listed companies to choose from. Job aims to invest in those which have strong balance sheets, those that offer a margin of safety in share price terms, and have demonstrably sustainable cash generation to support both dividends and capital expenditure for the future growth of the company. Understanding that he is investing people’s hard-earned savings, Job believes in maintaining a diversified portfolio, with around 100 holdings at any one time.

Job emphasises that dividend yield is a key attraction for him when selecting investments, but that he tries to achieve a blend of higher and lower yielding companies through the portfolio. The resulting breadth of income sources is a key part of his approach, and is part of the reason for such a strong dividend record on the trust. Overall, Job believes that dividends form a decent part of overall returns for the vast majority of companies. In his view, selecting those companies that have the discipline of paying consistent and growing dividends, results in a high-quality portfolio which should over time outperform passive equity indices.

NAV total returns over both the long and the short term have been ahead of both the FTSE All Share and the IA peer group average, but have been moderately behind those of the AIC UK Equity Income peer group (the trust’s benchmark). Job’s style is one in which he is not aiming to “shoot the lights out”, and as such he expects to outperform gradually over the medium to long term, fully accepting that over short periods he may underperform when sectors such as mining or technology shares outperform.

At the current price, the shares yield 4.7%, a decent premium to the AIC UK Equity Income sector weighted average of 4.1%. The trust’s record of paying an increased dividend for the past 52 consecutive years is important in this context. However, perhaps of more interest to investors is the fact that the same manager has been responsible for delivering a rising income for nearly 28 years. Over the very long term, generating a rising income every year is only really achievable using revenue reserves. Indeed, CTY has had to dip into its reserves seven times over the period in which Job has been running the trust.

In most years, the board aims to increase the dividend, but also retain a little of the income earned for the revenue reserves. As at June 2018, revenue reserves (after adjusting for the final dividend payable) amounted to 0.59x the current dividend level of 17.7p per share. In fact, the board has been able to add to revenue reserves (per share and as a proportion of the dividend) for the past six years, even though at the same time it has been increasing the dividend and diluting the revenue reserves through issuance of stock.

A premium rating has for quite some time been the norm for the trust. The board’s aim is that the share price should “reflect closely its underlying asset value” but also to reduce discount volatility. Over the eight years to June 2018, the trust has issued 145.7m shares, increasing the share capital by nearly 70%. The trust’s size increasing has also meant that the OCF has reduced over time to 0.41% in the last financial year.

Portfolio

City of London’s objective is to provide long-term growth in income and capital. The broader objective includes a reference to the “importance of dividend income to shareholders”, which cuts to the heart of CTY’s mission. CTY has an unrivalled record of increasing dividends paid to shareholders for 52 consecutive years; a quite staggering achievement. Indeed, there are no other investment trusts which have beaten this record, and (whilst we haven’t checked) think it very unlikely any OEIC will come close. We hazard that protecting the “income compounding” track record of the trust is likely to weigh heavily in every action taken by both the manager and board.

The company’s mandate also notes that in seeking to achieve its objective, this will be “principally by investment in equities listed on the London Stock Exchange”. Within the mandate, the manager has a certain degree of flexibility to invest outside equities, and outside the LSE. Job Curtis has had sole charge of CTY since 1991, and over the ensuing 28 or so years, has demonstrated opportunistic adventures into fixed interest, convertibles and equities listed on other exchanges around the world in order to boost the yield, or add an exposure otherwise lacking on London’s stock market. A current example would be Microsoft, which has few UK comparators, and which Job first picked up in 2011 thanks to its 3% yield at the time, and Job’s perception of the defensive characteristics of the Office suite. Currently the trust has only one fixed interest security, a Nationwide Building Society “Core Capital Deferred Share” which Job bought when issued in 2013 and which has a 10.25% coupon. He wistfully regrets there not being more opportunities like this in the current environment! The overseas exposure is currently c.10% reflecting the relatively low yields on equities in Europe and the US (and thanks to the de-rating that Brexit has brought to UK stocks), but Job has flexibility to invest up to 20%.

At a time when it is so easy to invest globally, when we challenged Job on the relevance of having such a “UK bias” to the mandate, he pointed out that the LSE attracts many international companies to it because of the dominance of London’s financial services sector. Combined with the “dividend culture” that has been established over a long period of time, the UK is one of the best places in the world to invest for dividends. In Job’s view, even if he had a truly flexible mandate, the UK would be an excellent starting point to achieve the trust’s aims. Job aims to invest in companies that have strong balance sheets, in share price terms offer a margin of safety, and have demonstrably sustainable cash generation to support both dividends and capital expenditure for the future growth of the company. Understanding that he is investing people’s hard-earned savings, Job believes in maintaining a diversified portfolio, with around 100 holdings at any one time. He uses the FTSE All Share index as a sense check on the shape of the portfolio, and prefers to have large caps (FTSE 100 typically represent 60-70% of the portfolio) rather than mid/small caps. As the table below shows, none of the holdings is allowed to get particularly large – either in capital terms, or as regards contribution to revenues.

Source: Janus Henderson

Job describes himself as a “pragmatic” investor, and one that recognises the contribution of income to total returns, but that valuations (as distinct from qualifying as a “value” stock) are important in determining whether he should be adding or reducing exposure to a holding. As we refer to above, he prefers companies that have good free cash flow yields, strong balance sheets and growing earnings. These qualities lead him to three themes that are prevalent within the portfolio currently.

The first is the long-term growth potential from emerging markets, balanced by the resilience within developed markets from the consumer staples companies. Job has a big overweight relative to the FTSE All Share index at 14.4% of the portfolio. He has been adding to Nestle, Coca Cola and Reckitt Benckiser over the past couple of months, underlining his confidence in their attractive qualities, but also his conviction that a Corbyn government in the UK will have absolutely no effect on their earning trajectory. The second theme that Job highlighted was his 10.3% exposure to oil stocks. He has held overseas oil companies in the recent past, but now only holds BP and Shell for their “self-help recovery” stories. Each has achieved significant reductions in costs and so are well set for delivering a strong dividend stream for the foreseeable future. The last theme is banks which add up to 8% of the portfolio (albeit an underweight relative to the FTSE All Share). Job believes that their capital positions are greatly strengthened, and that many lessons have been learnt from the financial crisis. The same goes for housebuilders which Job has had a decent exposure, in which managements have strengthened balance sheets and learnt plenty of lessons which should enable them to pay strong dividends to shareholders.

Job emphasises that dividend yield is a key attraction for him when selecting investments, but that he tries to achieve a blend of higher and lower yielding companies through the portfolio. Indeed, within the top ten holdings, the Bloomberg forecast yields for the year ahead (22nd Jan) vary from 7.8% (British American Tobacco) to 2.4% (Diageo). The resulting breadth of income sources is a key part of his approach, and part of the reason for such a strong dividend record on the trust. Overall, Job believes that dividends form a decent part of overall returns for the vast majority of companies. In his view, selecting those companies that have the discipline of paying consistent and growing dividends, results in a high-quality portfolio which should over time outperform passive equity indices.

Gearing

Shareholders in CTY can expect gearing to move between a maximium of 20% of NAV (except in exceptional market conditions) and net cash of 10%. CTY has had fixed rate structural gearing for quite some time, and as a result, has had some headwinds to contend with in terms of the relatively high interest rates payable. However, as we note above, the company has been steadily growing over time through share issuance which has reduced the effect as the debt becomes proportionately smaller. Of interest to investors, the most expensive debentures (£10m paying coupons of 10.25% and £30m paying 8.5%) mature in 2020 and 2021 respectively, which leaves two relatively low cost privately placed lines of gearing: £35m paying 4.53% and maturing in 2029, and the recently issued £50m worth paying 2.94%, redeeming in 2049. In addition, the trust has a £120m overdraft facility, which attracts interest payable at 1.25% above the base rate to the extent that it is drawn.

The trust has a policy that the fixed rate gearing is strategic and will usually be fully invested, but there have been times when the gearing effect has been reduced by selling a FTSE 100 Future. On the other hand, the bank facility is managed tactically, depending on market levels, by Job in consultation with the Chairman and the Board. Typically, Job looks at a range of absolute measures (such as P/E ratios) relative to history as well as the yields available on stocks to determine what level of gearing he find appropriate. As an absolute maximum, gearing will not exceed 20% of NAV at the time of drawdown. Currently, the fixed rate borrowings amount to 9.1% of NAV, meaning that Job has employed a small amount of the overdraft facility to bring the current overall level of gearing to 11.9% (as at the end of December 2018).

Whilst the historic debentures together add up to only £40m of capital, the positive effect of their maturing in the coming years will be two-fold. In capital terms, the “cum-fair” NAV will gently drift upwards (all things being equal) as the “value” of the debt assuming it were to be repaid today is currently greater than “par”. In interest cost terms, 56% of finance costs over the past financial year were attributable to the 2020 and 2021 debentures, whilst only representing around 25% of the total borrowings. As the more costly forms of gearing roll off, the trust will have more distributable income for dividends, although it is worth noting that the effect will be muted given that 70% of interest costs are charged to the capital account.

Performance

The trust’s objective is to provide long-term growth in income and capital, but as we refer to in the portfolio section, providing a rising dividend to shareholders is a key requirement from the board of the manager. As we detail in the dividend section, the trust has delivered on this admirably, generating an unrivalled 52 years of consecutive dividend growth. In terms of total return performance, the benchmark is the weighted average of the AIC UK Equity Income peer group. Having a peer group benchmark makes a lot of sense given that generalist equity indices don’t have an “income” mandate”. However, over time CTY has grown considerably and is currently the largest trust in the UK Equity Income sector. As such, the weighted average of the peer group’s performance has been increasingly influenced by CTY’s own performance (according to numbers from JPMorgan Cazenove, CTY represents c. 15% of the sector). So whilst the AIC peer group remains the benchmark, the board also considers the performance of the FTSE All Share Index as well as that of the IA UK Equity Income sector when reviewing performance.

As the graph below shows, over the long term (10 years) NAV total returns have been ahead of both the FTSE All Share and the IA peer group average, but have been moderately behind those of the AIC peer group. As we discuss below, Job’s style is one in which he is not aiming to “shoot the lights out”. As such, he expects to outperform gradually over the medium to long term, and fully accepts that over short periods, he may underperform during periods in which sectors such as mining or technology shares outperform.

Source: Morningstar

This characteristic is shown in the calendar year performance numbers which illustrate that CTY is never far from the peer group, but relative to the FTSE All Share Index has outperformed and underperformed by quite some margin in different years. As we touch on above, Job uses this index as a reference point for sector exposures, but has total flexibility when it comes to investing in them. As such, when certain sectors move strongly, depending on their respective weights, Job’s performance will deviate. Over the long term, given his fundamental approach to understanding companies and investing in those who can sustainably grow their dividend, Job has proved he can outperform the FTSE All Share.

Source: Morningstar

Performance over the last five years, remains within the expected pattern, with CTY broadly in-line with the peer group average, but ahead of the FTSE All Share index.

Source: Morningstar

Dividend

At the current price, the shares yield 4.7%, a decent premium to the AIC UK Equity Income sector weighted average of 4.1%. However, one of the key selling points of CTY is its dividend track record, which has seen the board pay an increased dividend for the past 52 years. Whilst this is relevant, of more interest to investors is that the same manager has been responsible for delivering a rising income for nearly 28 years. Over the very long term, generating a rising income every year is only really achievable using revenue reserves to patch up the income account when shock events occur, an advantage that investment trusts have over their open-ended peers. Indeed, CTY has had to dip into its reserves seven times over the period in which Job has been running the trust. The most recent year in which this happened was in the aftermath of the 2008 financial crisis, when Job recalls that around 25% of FTSE 350 companies reduced or entirely cut their dividends. As a result, in the financial year ending June 2010, the company suffered an earnings fall of 9%. Dipping into its revenue reserves to the tune of 0.57p per share enabled the company to grow the dividend in the same year by 2.75% - not a bad result given the turmoil seen elsewhere.

In most years, the board aims to increase the dividend, but also retain a little of the income earned for the revenue reserves. As at June 2018, revenue reserves (after adjusting for the final dividend payable) amounted to 0.59x the current dividend level of 17.7p per share. In fact, the board has been able to add to revenue reserves (per share and as a proportion of the dividend) for the past six years, even though at the same time it has been increasing the dividend and diluting the revenue reserves through issuance of stock. For example, since 2014, the company has had an average payout ratio of 93.4% of distributable income. This has had the effect of boosting the revenue reserve cover based on the dividend level applicable at the time from 0.53x to 0.58x, whilst at the same time the number of shares in issue has increased by 60% and the dividend increased by 20% over the same period.

Source: Janus Henderson

As we note above, this dividend growth is driven by dividends generated by Job’s stock selections alone, with his preference for conservatively run, well-financed businesses which are themselves not overdistributing (and thereby endangering the long-term sustainability of earnings). Job also tries to ensure that with a well-diversified portfolio, he is not held hostage to fortune by one particular sector or stock in terms of overall revenues. Overall, Job aims for a portfolio yield of between 110% and 130% of the FTSE All Share. However, at times he has latitude to invest in fixed interest (where opportunities present themselves), and also write covered options to boost income. Currently neither of these are making much of an impact on revenues. As we discuss in the portfolio section, Job only has one fixed interest security in the portfolio currently (0.6% of the portfolio). Writing covered options, and collecting a premium for doing so works well during periods of heightened volatility (when dividends are also called into question). As such, whilst option writing doesn’t feature highly at the current time, it does offer a way of boosting income when dividend income looks a little less rosy.

Management

Job Curtis has had responsibility for City of London since 1st July 1991. He is supported by the wider team of twelve at Janus Henderson who contribute to ideas and lead company meetings. However, Job has ultimate responsibility for any stock in the portfolio, and we understand that he enjoys doing his own fundamental research. Job co-manages a £4.5bn Global Equity Income open-ended fund with Ben Lofthouse and Alex Crooke, which he says helps provide an international perspective on the companies he looks at listed in London. More importantly, it ensures that he always has a good handle on relative valuations and earnings growth across the world.

Job describes himself as a pragmatic investor, but one that recognises that valuations (as distinct from qualifying as a “value” stock) are important in determining whether he should be adding or reducing exposure to a holding. Job has c 225,000 shares in the Trust, equivalent to £870,000 worth.
Janus Henderson is the result of the 2017 merger between the UK’s Henderson Global Investors and the UK’s Janus Capital. Both companies offer largely bottom-up, analysis-based strategies. In total Janus Henderson manage 14 investment trusts with combined net assets of £6.4bn.

Discount

City of London has consistently traded at a premium to NAV for much of the past five years. There has been the occasional hiccup to this pattern, but as the graph below shows, a premium rating has for quite some time been the norm. The board’s aim is that the share price should “reflect closely its underlying asset value” but also to reduce discount volatility. To this end, it has been a consistent issuer of shares. Indeed, over the eight years to June 2018, City of London has issued 145.7m shares, increasing the share capital by nearly 70%. The board issues stock to ensure that the shares do not trade too richly relative to NAV, but the other effect – of the trust’s size increasing, has also meant that the OCF has reduced over time. For example, in 2009 the OCF was 0.44%, compared to 0.41% in the last financial year. One other benefit, specific to CTY, is that as the size of the trust has increased, the relatively costly fixed rate borrowings become smaller as a proportion. Thanks to its significant growth, CTY is currently the largest trust in the AIC UK Equity Income sector, and has consistently traded at a premium to the average of the peer group.

Source: Morningstar

Charges

CTY is the largest trust in the UK Equity Income sector, and it also has the lowest OCF at 0.41% (financial year to 30th June 2018). Janus Henderson charge a management fee of 0.365% of [net] assets up to £1bn, and 0.35% above that indicating that the trust is harnessing significant economies of scale in keeping it’s OCF so low. There are no performance fees payable.

February 2019