Over the course of this testing Covid-scarred year, we have seen a significant reduction in income streams from charity investments, as the swathe of reductions in UK dividends paid out in 2019 has started to show up in portfolios. A yield on a typical charity portfolio of over 3.5% during the latter part of 2019 has now become a yield of closer to 2.5%. This has come to pass not by way of a huge surge in capital values, rather a savage reduction of c50% in the overall level of dividends from UK companies.
There is nothing that can be done now about the reductions in dividends that have taken place. There is, however, quite a lot that has been done already and can continue to be done, to secure the sustainability of future income streams. We are fortunate at the moment, in that there are many income opportunities available in the global capital markets, particularly in the investment trust sector. Below we set out how we have been addressing the task of repairing income streams in the management of typical charity portfolio.
The first port of call has been a thorough review of UK equity holdings, to ensure that we are as confident as we can be about the ongoing prospects of the individual companies in which we invest.
We have observed the significant reduction in dividends from BP, Shell, HSBC, Barclays, Lloyds, Rolls Royce and a whole roster of other UK blue chips. The key issue now is to assess how safe the remaining dividends are, what are the risks of further reductions and what is a realistic time scale for the company to resume dividend payments.
The above review has involved a detailed analysis of the balance sheet strength of individual companies, a stringent assessment of the underlying cash flows of the businesses and a critical assessment of the likely future strength of their franchise in this Covid world.
There is nothing fair or just about how the individual economic sectors have been impacted by this cruel pandemic. The harsh reality is that the banking, oil and gas, property, airline, catering, cruise and hotel industries have unfortunately all been very badly hit and the investment risks here need to be assessed very carefully.
In the above sectors there may well be some significant recovery potential in these distressed sectors and we are mindful of this. Our first task, however, has been to assess where the risks lie and to ensure that our portfolios do not have an unintended significant exposure to these higher risk areas.
On the other side of the coin, we have been increasing our exposure to those areas of the UK equity market where we previously had a high level of conviction about the quality of the underlying business and the security of the dividends, where this remains the case.
Many of these investments have been held in our portfolios for several decades, truly proving their worth over many economic cycles. They have remained conviction holdings, sitting solidly and stately in our portfolios, each year compounding their high returns on capital and allowing investors to benefit from their strong underlying cash flows. Such useful long term holdings have this year become literally worth their weight in gold.
We have used a number of other investments in the UK to reinforce our income streams. Some of the well-established general investment trusts have a distinguished history of continuing to pay out dividends during the vicissitudes of many economic cycles. A notable feature of the investment trust sector is that many trusts have revenue reserves that have accumulated during the good years that are available to distribute when the going gets tougher, as has become the case recently.
We have been using selective investment trusts to strengthen our income streams, where the management teams are committed to maintaining the dividend. There are attractive current yields of 5% available from some of these trusts, which contain mainly higher yielding UK equities that are backed by strong levels of revenue reserves covering the dividend.
Outside the UK equity market, we have been looking at the strong cash flows available from many Japanese companies in order to access a secure and growing level of dividend income. Warren Buffet has recently spotted the potential value in some long-established Japanese trading houses, and we share his views in terms of potential good long-term value in many areas of this particular equity market. We have been investing in income focused funds that invest in higher yielding Japanese equities. Some of these vehicles provide yields of over 3% where there is a very good chance that the dividend is growing ahead of inflation. Abe’s reforms have certainly resulted in a change in corporate culture. This has resulted, in many cases, in a greater focus on shareholder returns, although we note the continuing high levels of government debt. The relatively low level of current dividend payout ratios for many Japanese companies, relative to the UK in particular, is a useful potential source of future income for our charity portfolios.
In the mighty US equity market, while we have seen significant capital gains generated since the March lows, there are relatively few income investments that are available from this market. We do, however, use selected exchange traded funds to access those companies who have a distinguished long term track record of paying an increased dividend each year.
One key area of the global economy where we have been reinforcing a long held position is in the infrastructure sector. Yields of between 3.5% and 4.5% are regularly available from this part of the economy, from both open and closed ended investment vehicles. We believe that the sound underlying cash flows here will provide a relatively safe and stable source of long-term future income streams. We are likely to see an increased level of expenditure on infrastructure projects from many governments around the world, if politicians are to be taken at their word. As long as these projects are managed sensibly and there is a strong focus on generating sustainable returns, this sector is likely to feature even more prominently in our portfolios in the future than it does at the moment, where typically we have weightings of over 5%.
In the property sector, we have relatively little exposure to mainstream commercial property. We prefer to use quoted specialist vehicles to access the 4% yields that are available here, with the potential to secure some longer term capital growth from investment in the industrial warehouses and logistics – critical infrastructure for the online retail sector. Recently, we have invested in a new investment trust in the property sector that is looking to find accommodation for the 300,000 plus homeless people in the UK, while providing investors with a 5% yield indexed to the CPI. This is, we believe, an example of the market economy in action at the sharp end, endeavouring to make a social impact in a critical area whilst delivering good returns for investors.
The stock market continues to develop new types of investments to help investors meet their income requirements. This includes vehicles that are involved in the commercial management of the intellectual property rights relating to the music industry. The premise is that the stable and predictable cash flows of the best known song books should be less impacted by the economic cycles. These cash flows in turn should become more valuable, as the global music streaming business grows over time. Whilst it is early days for this type of industry, the virtuous circle potential here could support cash flows that generate an income yield of c5%.
Turning to the world of bonds, the historically low yields on the vast majority of government bonds continue to pose a problem for income investors. We remain underweight bonds generally as an asset class in our various charity mandates; within the bond universe itself, we are very underweight government bonds. The yields on UK gilts of c1% are not attractive compared to the market expectations for inflation of c2% pa over the medium term. For our bond exposure, we continue to use a combination of lower yielding government bonds, higher risk, higher yielding corporate bond funds and selected shorter duration vehicles. This combination is used to target a yield in the order of 4% pa from this part of our charity portfolios.
The wide-scale reductions in UK equity dividends that we have seen thus far in 2020 have come as something of an unpleasant surprise for charity trustees. These cuts have had a significant adverse impact on charity portfolios, appearing to undermine one of the central tenets of long-term equity investing. Capitalism has proved itself, however, to be as adaptive and flexible today, as it has been over many decades. Given the many income opportunities currently available in the capital markets, both in the UK and elsewhere, and some sensible, well-directed active management of portfolios, all is not lost on the income front for UK charities.
Philip Young is managing director at Close Brothers Asset Management
Charity Finance wishes to thank Close Brothers for its support with this article