City of London targets insurers and consumer stocks

City of London is less allocated to small caps and has less debt than some of its peers, while some, such as (IC Top 100 Fund) Edinburgh Investment Trust (EDIN), make larger sector and individual share allocations. Fund research company Morningstar gives City of London its highest rating: gold, for reasons including its strong management and consistent investment process. Jackie Beard, director of closed-end fund research at Morningstar, says the AIC UK Growth & Income sector is fairly diverse, and when City of London is compared to its Morningstar category, UK Large-Cap Blend Equity, it does better. Over the long term it has steadily outperformed both Morningstar peers and the All-Share index, though can get left behind when markets streak ahead.

The main detractor to City of London's performance over its last financial year was its underweight position in banks. "It would have been difficult to hold either Lloyds (LLOY) or Royal Bank of Scotland (RBS) because they did not pay a dividend," says Job Curtis, manager of City of London. "The holding in Standard Chartered (STAN) was switched into HSBC (HSBA) which was on a lower valuation and offered a greater geographical spread of operations. HSBC offers a yield of around 4.4 per cent which is very attractive."

The trust targets a yield of between 15 and 30 per cent greater than the FTSE All-Share Index and currently yields 3.96 per cent. It has raised its dividend every year for 47 years - a longer record than any other investment trust.

City of London has around a fifth of its assets in financials, but insurance and real estate account for a good deal of this - both areas in which the trust is overweight, with around 7.5 per cent of assets in insurance and 3.3 per cent in real estate.

"An overweight position was maintained in the life assurance sector where most of our holdings performed well, especially Standard Life (SL.) which produced a return of some 60 per cent over the 12 months," explained Mr Curtis. "The one disappointment in this sector was Aviva (AV.), which cut its dividend, and this holding was reduced. In non-life insurance, a new holding was purchased in Direct Line (DLG), the market leader in UK personal motor and home insurance which has scope to improve its return on equity through reduction in losses on insurance policies and cost savings. A holding was also bought in Munich Re, one of the world's leading reinsurers, at a share price valuation which did not reflect its strong track record. The holding in RSA (RSA), the commercial insurer, was sold after its disappointing performance and dividend cut."

Some of the trust's defensive holdings also underperformed, which he says was partly due to the switch into cyclicals and the rise in bond yields. "Utilities are considered by some as proxies for bonds and react adversely to falling bond prices," he says. "However, the inflation-linked nature of UK utilities regulated revenues is attractive to long-term investors. This point was well illustrated by the takeover approach for Severn Trent (SVT) which is held in the portfolio. The market underestimates utilities, a good bedrock for income funds. SSE (SSE), Centrica (CNA) and National Grid (NG.) offer an attractive combination of dividend yield and growth."

The trust has about 8.8 per cent of its assets in utilities.

The trust maintained its level of debt between 6.8 and 10.5 per cent during its last financial year and this contributed to performance by 2.1 per cent, on top of stock selection which contributed 4.05 per cent. Mr Curtis does not plan to significantly increase this level of debt, though adds: "The market could consolidate in the short-term, although we are optimistic on this on a 12 month view and I don't want to see it fall below 8 per cent."

One of the investment trust's main themes is consumer stocks and it is biased towards international companies invested in economies likely to grow faster than the UK. Examples include Reckitt Benckiser (RB.) and a holding in Nestle, which makes 40 per cent of its revenues from emerging markets.

"City of London's largest holdings partly reflect our belief in the structural nature of the growth in numbers of the middle class in emerging markets and their increasing prosperity," says Mr Curtis. "HSBC, British American Tobacco (BATS), Diageo (DGE) and Unilever (ULVR) all have significant exposure to emerging markets and will benefit from growing demand for their goods and services."

Like many investment trusts offering an attractive yield, City of London trades at a premium to NAV, currently about 2.58 per cent, but as demand for the trust's shares was strong over its last financial year it issued 19.1m shares worth £62.9m. City of London says its gross assets now exceed £1bn, meaning its expenses are spread over a broader base reducing costs to individual shareholders.

The trust also scrapped its performance fee in July and continues to have one of the lowest ongoing charges in the AIC UK Growth & Income sector, at 0.45 per cent.

Concerns have been raised about UK equity income funds holding many of the same shares as each other, creating concentration risk. But Mr Curtis says: "I do not having too much in one stock so my top 10 holdings are a lot less concentrated than some of my competitors. I like to be more diversified, as I like low volatility and run a conservative portfolio."

The trust has also recently invested in some more unusual holdings, such as Greencoat UK Wind (UKW), an investment trust which owns wind farms where revenues are underpinned by government subsidies. This trust has a 5.69 per cent dividend yield that is expected to grow with inflation.

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The trust also holds John Laing Infrastructure investment trust (JLIF), and has bought GCP Student Living (DIGS) which owns student accommodation in London, where demand is expected to remain strong and supply is constrained, and has an attractive yield.

"I like alternative income sources but in small doses," says Mr Curtis.

Source: Morningstar

Performance data as at 25 September 2013