A UK income trust that has delivered

While its conservative investment approach has done particularly done well during this year’s market rollercoaster, the trust’s consistent track record speaks of a longer-term success. Its 85-stock portfolio invests in UK equities with a bias towards large, multinational companies.

Stock picking has driven its recent outperformance. True, its choices have not always been of the most ethical kind - but much depends on which bits of the environmental, social and governance (ESG) spectrum you worry about. And there is a debate to be had here.

Sin stocks

Much has been written about ‘dirty’ energy stocks delivering the goods this year, and indeed City of London Investment Trust has sizable positions in both Shell (SHEL) and BP (BP.), as one might expect from a UK-focused income trust that is skewed towards large-caps.

However, the bigger picture is that the trust is underweight not just in Shell – the allocation was slashed when the company cut its dividend in 2020 – but also in the energy sector as a whole. Despite its circa 1.5 per cent position in TotalEnergies (FR:TTE), which has been increased in the past year, as at June 2022 the trust was still 2.6 percentage points behind the FTSE All-Share Index weighting for oil, gas and coal exposure.

So the trust’s environmental credentials could be worse, all in all. But its ethical investing profile still leaves something to be desired, because a good portion of the trust’s outperformance has been driven by its bets on the defence and tobacco sectors. Buoyed by Russia’s invasion of Ukraine, defence contractor BAE Systems (BA.) was the biggest contributor to the trust’s performance in the year to June 2022. To a degree, how 'dirty' you consider such a holding depends on political views.

“In my opinion, the weapons that BAE makes are essential in defending democracies against dictators,” says Job Curtis, City of London's long-serving portfolio manager. ESG rating provider Sustainalytics a consultancy, rates the group's ESG risk as ‘high’ but says it is ‘strong’ in managing it, and places it 22nd out of 95 companies in its industry group. 

Curtis is an experienced manager who has run the trust for more than 30 years. He says that “ESG considerations are a fully-embedded component of its investment process”. When assessing a company’s business model, the fund's managers will identify “fundamental ESG factors which may impact its profits, cash flow and dividends and the processes in place to manage them”.

Regarding the trust’s other 'dirty' performance drivers, tobacco stocks Imperial Brands (IMB) and British American Tobacco (BATS), Curtis says the pair had been significantly undervalued, and that the second is “better placed to transition towards less harmful products” than the first. In June, the trust was overweight to tobacco by three percentage points. British American Tobacco has been the trust’s biggest holding since 2020. As Investors' Chronicle has recently argued ('Quality tobacco as the economy goes up in smoke', IC Alpha 20 June 2022) tobacco stocks face long-term challenges but could provide some respite in the current economic environment, at least for those investors who can stomach them.

Source: City of London Investment Trust

Source: City of London Investment Trust

A long track record

Figuring out whether a portfolio's outperformance is a fluke or the result of careful planning can be hard at the best of times. Often there is an element of both, but in the long term, luck evens out.

City of London trust has consistently beat its benchmark on a three, five and 10-year basis, a solid result for a manager with a conservative approach. Stock selection has contributed positively to the trust’s performance for seven of the past 10 years – excluding 2021, 2018 and 2017, according to annual reports.

As Helal Miah, investment trust analyst at City boutique Kepler Partners, puts it, Curtis “has guided the portfolio through several previous crises and bouts of volatility”, which “gives him the confidence to do what he does best; that is, build a portfolio of quality and value-biased companies that generate steady cash flows with capital growth potential, while not becoming overly concerned by short-term volatility”.

The investment trust has been adept at making the most of its closed-end structure. With a 56-year uninterrupted track record of dividend increases, it tops the Association of Investment Companies ‘dividend heroes’ table. The ability to pay and increase dividends even during a rough patch is a key advantage of owning shares in an equity income trust instead of holding stocks directly, and something that those who draw income from their portfolio might especially appreciate.

City of London has proved its determination to maintain its dividend record. In 2020 and 2021, when earnings suffered due to the Covid-19 pandemic, it used its reserves to maintain its pay-out until, in the year to June 2022, its earnings per share returned above its dividends per share.

The trust also employs gearing to enhance performance. This contributed 1.5 percentage points of growth in the year to June 2022. That said, the fixed costs associated with gearing will always be a drawback when markets move the wrong way. 

Due to its recent popularity, at times this year the trust’s shares have been trading at a higher premium to net asset value (NAV) than usual. With shares in the vast majority of its peers trading at below NAV, the idea of paying extra for what is ultimately a bunch of UK stocks can be slightly off putting. But we think the trust is popular for good reasons, and ultimately its dividend track record and recent performance make it stand out. Importantly, issuing new shares has kept the discount from spiralling upwards – it was 2.7 per cent on October 31, against a 1.3 per cent one-year average. 

Outlook

It remains to be seen whether City of London trust will be able to keep outperforming its peers, but for now it looks well positioned. Recent additions to the portfolio include Natwest (NWG) and wealth manager Rathbones (RAT). As the trust is underweight in HSBC (HSBA), the first seems like a solid shout to help it take advantage of rising interest rates.

Rathbones is replacing the trust’s holdings in Brewin Dolphin, which was its third-best performing stock for the year after Royal Bank of Canada agreed to acquire it. Rathbones was purchased “at a considerable discount to the valuation at which Brewin Dolphin was taken over”, the trust’s annual report notes. Wealth managers are increasingly attracting the attention of big banks looking to diversify their businesses. 

Technically a UK-focused trust, City of London trust actually provides a decent level of geographical diversification. While just 16.4 per cent of its portfolio is composed of non-UK stocks, its big-company bias means only about a third of its underlying revenues are generated domestically. Emerging markets account for about a fifth. “In terms of revenue exposure CTY can be seen as a geographically-diversified portfolio, with some of these regions offering better growth potential than the UK,” says Kepler's Miah. At the same time, UK stocks are still looking relatively cheap and offer attractive dividend yields.

True, City of London Investment Trust is not built to shine in a bull market and there is a chance that it could trail its peers once the recovery is in full swing. However, those times still seem distant. Meanwhile its investors get a cautious and consistent approach, exposure to defensive stocks that should do well in a recession and a 5 per cent yield from a dividend that just keeps rising. Buy. 

As at 31 October 2022. Source: AIC.

As at 31 October 2022. Source: FE.