City of London 14 October 2019

City of London’s (CTY) objective is to provide long-term growth in income and capital. Bearing in mind the fact that this trust has the longest track record of providing annual dividend increases in the investment trust sector – 53 consecutive years – it is also true that a rising level of dividend income is a very important part of what CTY aims to provide for shareholders.

In the context of this very long track record having been developed by the company, it is reassuring for investors that the last 28 years worth of dividend increases have been delivered by the same manager: Job Curtis. Job has sole responsibility for CTY, although as we discuss in the Management section, he leans on his team members in Janus Henderson’s global equity income team to help him form ideas about relative valuations and changing industry dynamics.

Within the mandate, the manager has a certain degree of flexibility to invest outside equities (opportunistically in fixed interest or convertibles), and outside the LSE. As at the end of June 2019, Job had 10% invested overseas, in companies which all offer either better income opportunities or non-replicable exposures to that found in the UK. Overseas holdings (and income received in foreign currencies) have clearly had a beneficial impact over the last few years, but with the end to the Brexit process potentially looming, Job is gently positioning CTY towards more domestically-focused areas. He has built up exposure to what he views as resilient domestic themes such as UK housebuilders, and travel and leisure businesses, which should generally benefit from a rise in sterling, and which add portfolio stability.

Fundamentally, Job aims to invest in companies that have strong balance sheets, which, 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. He likes to spread investments across a wide variety of companies. The board has encouraged him to concentrate the portfolio very slightly, which over the last financial year saw the number of stocks come down from 117 to 97.

Valuations are an important determinant in the investment process. Job has been paring back exposure to what he views as very highly rated ‘quality growth’ stocks, and reinvesting in high quality cyclicals and value stocks. This subtle shift shows up in our correlation analysis, and CTY has recently become more highly correlated with ‘value’, whilst correlation to ‘growth’ has declined. In our view, this is an interesting by-product of the investment process of CTY and a cautious UK equity income mandate. As a pragmatic and experienced manager, Job instinctively sells into ‘hot’ areas of the market, recycling into less well-appreciated areas.

NAV total returns over both the long- and the short-term have been ahead of the FTSE All Share index – which this year replaces the AIC UK Equity Income peer group as the benchmark. Job’s style means he is not aiming to ‘shoot the lights out’ in any one year by having particularly large weightings to any one sector. As such, he expects to outperform gradually over the medium to long term, and fully accepts that over short periods, he may underperform. We observe that the dividend focus and investment strategy generally lends itself to the trust outperforming during periods of market difficulty; since June 2008, the trust has outperformed the FTSE and the Morningstar Equity Income sector more often during periods where the FTSE All Share has fallen over the previous 12 months. Conversely, it has tended to lag in rising markets.

At the current price, the shares yield 4.5%, a decent premium to the AIC UK Equity Income sector weighted average of 3.9%. 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 53 consecutive years – the longest track record in the investment trust sector. The board has been able to add to revenue reserves for the past seven years, such that revenue reserves (as at 30 June 2019) are were 0.83x the current dividend level of 18.6p per share.

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. The company continues to issue shares, which over time has enabled the board to negotiate lower fees with Janus Henderson. The OCF was 0.39% in the last financial year, and the board predicts it will fall further once recently negotiated lower management fees have had a full year’s impact.

Job’s preference for conservatively run, well-financed businesses clearly lends itself well to the mandate. He always refers to his desire to have a good spread of investments, which means CTY is unlikely to be held a hostage to fortune by one particular sector or stock in terms of capital or income. Indeed, as a pragmatic and experienced manager, Job instinctively sells into ‘hot’ areas of the market, recycling into less well-appreciated areas. Our analysis shows that CTY has recently become more positively correlated to ‘value’, whilst correlation to ‘growth’ has reduced.

CTY continues to be the poster-child of the UK equity income sector. It delivers on its promises with exceptionally low charges, and has a strong manager with long experience at the helm. 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 as well as deliver rising dividends year in, year out.

CTY uses long-term structural gearing as well as short-term tactical gearing. Currently, only the fixed rate borrowings – amounting to 9% of NAV – are employed (as at the end of August 2019). Overall, Job believes that the portfolio beta is typically in the order of 0.9-0.95. This means that with the structural gearing employed, this doesn’t necessarily mean that the trust at the NAV level will be significantly more exposed to market moves.

The board recently changed the benchmark to the FTSE All Share index. Previously, this was the weighted average of the AIC UK Equity Income peer group. Aside from the fact that CTY is amongst the largest trusts in the sector (thereby influencing its old benchmark), the makeup of the equity income peer group is increasingly less consistent. As such, it seems entirely logical that the board should make this change. Certainly, it comes from a position of strength (the trust was ahead of the previous benchmark over one, three, five and ten years at 30 June 2019, when it made the change).

In our view, as well as the strong performance, the low charges are one of the reasons that CTY continues to issue shares and grow its asset base – which has proven a virtuous circle for all concerned. As the trust gets larger, the OCF should continue to fall, thereby increasing its appeal in these very fee-conscious times.