Trusts with a war chest of cash can weather stockmarket storms

As is often the case in the first quarter, global stock markets made a decent start to the year. In sterling terms, the leading global indices gained between 3.7% (the FTSE 100 index) and a very healthy 12% (the FTSE Asia Pacific ex Japan index). Here in the UK it was smaller companies, particularly stocks listed on the Alternative Investment Market, that were among the best of the bunch (see pages 30 and 34 for more on AIM). The FTSE AIM All-Share index gained 10%, while the top 100 stocks in the index put on 12.3%.

That strong performance validates enthusiastic comments, late last year, on AIM's prospects from fund managers of Money Observer Rated Funds in the UK smaller companies asset group.

Jonathan Brown, who has invigorated the performance of Invesco Perpetual UK Smaller Companies trust since he took charge in June 2014, is among them. The trust's exposure to AIM-listed stocks has topped 30% for the first time and its consistently strong performance has resulted in it winning Money Observer's Best UK Growth Trust award.

Smaller companies value

As Brown tells us: "Good companies like AIMbecause it is much cheaper to list and it is much cheaper to issue new shares to fund their growth". Whether such "good companies" are listed on the main market or on AIM, Brown contends that there is a greater chance of finding good value among very small companies as they are further under investors' radar than their larger brethren.

Importantly, Brown says, "some are sufficiently niche to be able to do well even in difficult conditions." This latter comment resonates particularly now that the UK has fully launched itself into extrication from the EU by triggering Article 50 of the Treaty of Rome. Most investment professionals concede UK plc will find the process anything but painless. At best, business faces two years of uncertainty over our terms of trade with the EU and myriad "what if" scenarios when it comes to making corporate investment and planning decisions.

The Council of Europe, which has issued draft guidance for the European Commission's negotiations with the UK, will not countenance talks on post-Brexit trade terms until meaningful progress has been made on the terms of the divorce itself, which is expected to cost the UK taxpayer anything between £25 billion and £48 billion.

Should negotiations on the separation go well, then informal talks on a trade deal can start later in the process. Crucially, however, the Council has stated that formal negotiations cannot begin until after the divorce itself. An interim post-Brexit trade deal is the most likely outcome to an amicable divorce and will be far more desirable for both sides than leaving the UK on a cliff -edge. But this is where the PM's claim of "Brexit means Brexit" rings hollow. For the Council states: "Should a time-limited prolongation of Union acquis [legislation and court decisions] be considered, this would require existing Union regulatory, budgetary, supervisory and enforcement instruments and structures to apply". In other, simpler words, the UK will have to accept all current obligations of EU membership, including free movement of people and the jurisdiction of the European Court of Justice.

The PM's letter that triggered Article 50 and the Council's response are just the opening gambits in this high-stakes game of bluff and counterbluff. But what will be of particular concern to investors in UK plc as the negotiations progress is the stultifying effect on investment, productivity and, ultimately, jobs and profits.

Although the "phased approach" to negotiating Brexit may offer clues as to Britain's future relationship with the EU, nothing will be certain until a deal is ratified by the UK and EU parliaments.

Find a niche

That is why Brown's liking for companies which operate in niche markets that should do well even in difficult conditions resonates today, for these are the sorts of companies that should at least give investors a solid run for their money. Faced with this uncertain future, investors should be prioritising funds that invest in businesses with reasonably predictable profits and strong balance sheets, over those with prospects of high growth that may be difficult to fulfil.

The closed-ended structure of investment trusts is better suited to small company investing in the uncertain future that the UK faces. Should sentiment turn against the sector, trust managers will not need to sell holdings to meet investor redemption requests, unlike managers of their open-ended counterparts.

Despite their recent strong performance, some trusts in the UK smaller companies asset group are cheap when assessing their three year average share price discounts to net asset value. They include BlackRock Throgmorton (discount of 20%), Henderson Smaller Companies (15%) and Standard Life UK Smaller Companies (9%). The strong performance of the aforementioned Invesco Perpetual UK Smaller Companies trust, coupled with its recent commitment to pay a decent quarterly dividend (partly funded from capital if required), has anchored its discount to around the 5% mark.

Investors thirsting for income in a low interest world should also be favouring investment trusts for their UK exposure. I have been increasingly worried about the level f dividend cover in the UK over the past 18 months, and am even more concerned today, as it has fallen to a ratio of 0.88 for constituents of the FTSE 100 index.

Essentially this means last year's corporate profits will not be sufficient to maintain last year's dividend payments (the historic yield on the FTSE 100 is 3.7%) without some form of financial engineering, such as share buybacks or borrowing.

Dividend cover on the FTSE 350 Higher Yield index, which has 122 constituents from the FTSE 100 and FTSE 250 indices, is even lower at a ratio of 0.7. This does not bode well for open-ended UK equity income funds, for two reasons. First, the vast majority of funds favour the larger companies in these indices to fund their dividend commitments, and secondly, they must pay out all of the income they receive to their investors.

The trust advantage

Investment trusts, in contrast, can retain up to 15% of the income they receive annually to help maintain or even grow their payouts in leaner years, which are surely approaching. Many of them also look further down the market capitalisation scale for income and growth opportunities.

Here it is reassuring to see that dividend cover in aggregate is far healthier: the FTSE Small Cap (ex investment companies) index yields 2.9% and dividend cover is 1.69 – not great, but double that of the FTSE 100. Like the Small Cap index, the FTSE All-Small (ex investment companies) index has a high number of growth companies among its 194 constituents. Nevertheless, it too has a reasonable dividend yield of 2.77% and cover of 1.74.

As highlighted in January's Wealth Creation Guide (page 22), I can foresee a situation where Brexit stasis forces UK companies, particularly smaller companies, to put business investment plans on hold and return excess capital to shareholders, either through share buybacks or special dividends, or both.

But more important for income-seekers will be the ability of funds and trusts to continue funding their current dividends and hopefully to grow them as well. This is where the level of a trust's revenue reserves assumes great significance. Trusts that are members of our UK equity income Rated Funds asset group and which have a current yield in excess of 3% include Troy Income & Growth (3.5%), City of London (3.6%) and Lowland (3.5%). Revenue reserves on these three trusts amount to one year of the previous year's total dividend for Lowland, 0.7 years for City of London and slightly lower for Troy Income & Growth.

Elsewhere, one of the more overlooked trusts with a decent yield and strong recent performance to boot is JPMorgan Claverhouse. Not only does it yield 3.5%, it also has 1.4 years of revenue reserves to fall back on. Murray Income has the same level of reserves; and although longer-term performance lags the sector, there are signs that this Aberdeen-managed trust is staging a comeback, having gained a sector-beating 25% over the past year. Like the JPMorgan trust, it is trading on a wider than average discount of 10%.

Also managed by Aberdeen Asset Management, Shires Income (a member of the Rated Funds mixed asset – higher risk group) looks best placed to be able to maintain its dividend payouts. Currently yielding 5%, it has 1.7 years of reserves and its shares are priced on a 10% discount.

As the thirst for income goes on, and the ability of UK corporates to fund their current level of payouts is increasingly questioned – particularly as Brexit approaches – I believe investors at large will rekindle their enthusiasm for trusts such as these that hold a war chest of cash to fall back on when the going gets tough.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.