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The time is now?

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3 April 2020

David Prosser looks at recent discount movements in the industry and what this might mean for opportunistic investors.

During times of crisis, concepts that once seemed hypothetical and extreme can suddenly become incredibly important. So it is now proving with investment companies and their revenue reserves.

Investment companies are unique in being able to retain some of the income they earn on their portfolios each year; this buffer fund can then be used to support dividends to shareholders during leaner times. In recent times, when companies worldwide have offered higher pay-outs year after year, this facility has often felt somewhat superfluous. But today, as companies slash their dividends in the face of the Covid-19 pandemic, its tremendous value is once again being revealed.

Research from Investec Securities hammers home the point. It looked at the reserves of 17 investment companies in the equity income sector, modelling what would happen if dividend payments from companies fall by 30% over the course of this year. As Investec itself notes, “just a few weeks ago, to talk about a 30% cut in dividends would have sounded nonsensical”, but this is now roughly what the markets are predicting.

What would happen at those 17 funds in the event of such a decline? Well, Investec’s numbers suggest each one of them would still be able to offer a 3% increase in the dividend they pay to their own shareholders this year, with the shortfall financed from their reserves. Just to make that absolutely clear, Investec believes every single equity income investment company could raise its dividend by 3% this year even if their own income falls by almost a third.

There’s more, too. Investec has also modelled a year-two scenario, in which investment companies’ own dividend income falls by 30% again. With this outturn, eight of the 17 funds would still be able to raise their dividend by 3% once again, the analyst reports, given their current revenue reserves.

It should come as no surprise that there is a high degree of crossover between these eight funds and the AIC’s “Dividend Heroes” ranking, which lists 20 funds that have increased their dividend in every single year going back at least 20 years. JPMorgan Claverhouse, with a record of increasing dividends in 46 consecutive years, BMO Capital & Income (25 years) and Schroder Income Growth (23 years) all appear on both lists.

We have been here before. Just over a decade ago, dividends plunged by 17% as the global financial crisis wreaked havoc. Of the 14 equity income investment companies open for business at the time, 11 were still able to increase their dividends, two more kept pay-outs on hold, and only one wielded the axe.

For investors dependent on their portfolios’ income generation properties, this is absolutely vital. One common misconception about the Dividend Heroes is that they offer market-beating yields; advisers and investors are sometimes surprised when they discover higher yields are available elsewhere. Crucially, however, if you’re relying on your investment income, what you want more than anything else is consistency and dependability – this is what equity income funds, courtesy of their revenue reserves, are able to offer.

For those holding investment companies in income drawdown schemes, for example, this protection will provide vital reassurance. They can be more confident their income will continue to flow – and that they won’t have to break into their capital, crystallising the paper losses of the past few weeks.

In the end, the bad times will pass. But in the meantime, investment companies are already proving their mettle as a shelter from the storm.