Richard Troue: Have the bottle to back firms, not economic prospects

Investor sentiment has improved markedly in recent months, but it is easy to get carried away when stock markets rise. There is little to suggest a return to rapid economic growth is on the horizon. Western governments remain overly indebted and emerging economies still rely to a degree on exports to the West.

It remains important to divorce company prospects from the economic outlook. Some companies will thrive through thick and thin. I continue to believe that there is a place in most portfolios for strong, stable businesses which can offer great brands or franchises. Once people know and trust a product they buy it again and again, through necessity, loyalty or habit. Recurring revenues foster robust balance sheets, strong cash flow and rising profits. In turn this can lead to high and rising dividends.

For investors able to accept fluctuating capital values, equity yields currently look attractive. Longer term, the pricing power enjoyed by these companies means they should be able to pass on increases in their costs through higher prices, so maintain and even increase profits and dividends. Other things being equal investors should be willing to pay more for each share, giving the potential for capital growth as well.

UK companies paid £80.4bn in dividends during 2012; an all-time record. Corporate balance sheets remain in rude health and cash flows strong. While dividends are expected to grow this year, the underlying rate of growth is expected to slow.

This highlights a benefit of the investment trust structure. Investment trusts can hold back up to 15 per cent of their income each year to build up a reserve. It can be used to smooth dividend payments during years when growth is harder to come by, or if dividends fall.

The City of London Investment Trust plc, managed by Henderson's Job Curtis, currently has healthy reserves. The flexibility to use these reserves has helped the trust increase dividends in each of the past 46 years, even after the financial crisis.

Mr Curtis has been at the helm since July 1991, aiming to provide growth in capital and income from investments predominantly in larger, UK-listed companies. He considers himself a naturally cautious investor, and while he doesn't ignore the wider economic environment, his main focus is the prospects of individual companies.

He begins by looking for those with above-average yields and dividend growth prospects. He prefers highly cash-generative businesses backed by assets.

The portfolio is well diversified, containing more than 100 holdings. Presently, Mr Curtis is maintaining a "defensive core" in companies with international earnings and consistent dividend growth.

Companies supplying staple goods to consumers and those with strong brands that cannot be replicated easily fit the bill.

Diageo is a top holding. Its portfolio of brands, which includes Guinness, Smirnoff vodka and Johnnie Walker whisky, has a loyal following and it is benefiting from increasing demand in emerging markets.

Similarly, while he has generally avoided UK banks, Mr Curtis has been adding to a holding in HSBC which he believes offers an attractive dividend yield and a global footprint.

Banks performed well during 2012 and the portfolio missed out on some gains, though exposure to insurance companies, which were not affected to the same extent by the financial crisis, helped make up for this.

While the core of the portfolio is invested in less economically sensitive companies, Mr Curtis also has exposure to those more reliant on stronger economic growth. Quality is paramount. He seeks those with strong balance sheets, good intellectual property or technology and manageable debt. For instance, TUI Travel was added to the portfolio during 2012 as he felt it was capable of capitalising on weakness among competitors.

Investment Trusts have the ability to borrow money and the portfolio is approximately 11 per cent geared at present, offering an attractive yield of 4.2 per cent.

Ongoing charges for the last financial year were low at 0.45 per cent, although there is a performance fee. At the time of writing, the trust trades at a premium to net asset value of 2.1 per cent.

Mr Curtis has built a good, long-term record on this trust using a consistent approach with a focus on good-quality businesses. It could appeal to income-seeking investors with a long-term horizon who are comfortable with the investment trust structure and are seeking a core holding for their portfolio.

Richard Troue, investment analyst. www.hl.co.uk