Hail dividend heroes – but with a word of caution

Barely a week has passed since the stock market traumas of recent weeks than articles have appeared extolling the virtues of investment trust “dividend heroes”.

These are funds that have maintained their dividend payouts over many years, riding out market plunges and recessions. It has been an impressive achievement. And it is certainly true that they have helped the investment trust sector to avoid the worst of the falls suffered by major indices such as the FTSE 100 and the FTSE All-share.

And heroes they have certainly been. Among the most prominent are City of London Investment Trust, Bankers Investment Trust and Dundee-based Alliance Trust, which have raised their dividends for 53 years in a row. A further 18 also qualify as Association of Investment Companies (AIC) dividend heroes because they have raised their dividends for 20 or more years. These include Caledonia Investments, which has raised its dividends for 52 years. Seven trusts have increased their dividends for 40 or more years in a row and five have done this for more than 30 consecutive years. And they have contributed to the greater resilience shown so far this year: the FTSE Equity Investment Instrument Index is down 12.8 per cent, compared with a 22.3 per cent decline for the FTSE All-share index.

“Revenue reserves” – what a comforting thought that buried in the small print of trust annual reports and accounts will be a discreet item referring to such reserves – conjuring up visions of a stash of ready cash held back for rainy days – or more accurately at this time monsoons such as the coronavirus blight and devastation.

But what are these reserves, exactly? Of what do they comprise? And can they be relied upon to help income-dependent investors through difficult times without compromising the investment trust total return?

Now it’s certainly true that, unlike mutual funds that are obliged to pay out the dividend income they receive in full, investment trusts can hold up to 15 per cent of their income in good years so they can top up dividends paid to investors in the bad years.

But as the Monevator website pointed out in an article last month, this reserve is “simply a bookkeeping entry. It’s not a pot of cash tucked away in the fund manager’s attic.

“Tapping the revenue reserve will enable a trust to maintain – and even grow – its dividend. But there’s no adding a few notes from a fat wodge of crisp £50s going on here. Instead the manager will do what anyone else would if they were short of a few bob and needed income. They will sell some of the trust’s investments (its net assets, or NAV) and pay out the proceeds as part of the dividend.”

And that’s not, as the Monevator posting commented, “what most people think of when they hear ‘cashing in the rainy-day fund’.”

The advantage of a facility such as this is that investment trust managers can smooth dividend payments, giving investors a greater sense of security over income performance. But what of potential consequences?

What’s also relevant here is that back in 2012 the rules were changed so that investment trusts were able to pay out dividends from the cash raised by selling investments – even though these capital profits were not allocated to a revenue reserve.

So does the concept of a revenue reserve really have much meaning? If trusts can now pay dividends out of capital profits, a trust with zero revenue reserves could increase its dividend if it wanted to – assuming, of course, it made some profitable investments.

But there is no such thing as a permanent bull market with “forever” capital gains. If a trust suffers an income fall and has no gains on its investments, when would it be sensible to return cash to shareholders in this way? They could become “tomb raiders”, compromising accumulated total return.

“The ability of investment trusts to smooth their income payments is a nice enough feature,” cautions the Monevator posting. “But don’t get bedazzled by talk of revenue reserves or hints of some semi-magical ability to plump up dividends. To make up for a shortfall in income, investment trusts will mostly have to sell capital, just like anyone else.”

Two other rather contradictory factors should be borne in mind. First, some quoted companies may be using the Covid-19 emergency as an opportunity to reduce or pass their dividends to conserve cash in the face of a highly uncertain future.

The second is that some trusts, aspiring to join the hallowed band of dividend heroes – or anxious not to fall out of this sainted category – may maintain their dividend payouts and create a false sense of income security. After all, there has been a swathe of warnings from quoted companies that revenues and profits may be blighted for years to come – with airlines and hospitality businesses to the fore.

Let’s not detract from the signal achievement of dividend heroes. But let’s not be blinded either by notions of a physical stash of spare cash which trust managers can draw on without cost – particularly over a period when company dividend payments could take years to recover.

Some companies may be using Covid-19 to reduce or pass their dividends