By Peter Rae

Recently we wrote about the fact that few listed investment companies (LICs) reduced their dividends during the recent reporting season despite many reporting lower earnings. This reflected the fact that most LICs have a level of profit reserves that enables them to smooth dividends by holding back when profits are strong.

Our key measure for assessing LIC performance is total portfolio return, being growth in pre-tax net tangible assets (NTA) plus dividends, however, we understand that many investors in LICs are also focused on receiving attractive, fully franked dividends. So this month we take a look at the 10 highest yielding LICs in our coverage universe (refer to below table) and consider the outlook and sustainability of these dividends.

In order to be able to pay dividends, LICs need to generate profits. However, it is possible for LICs to pay out more than they generate in profits in a given year by dipping into retained profit or dividend reserves from prior years. So it is possible for LICs to smooth dividend payments to their shareholders by retaining profits rather than simply paying out 100% of earnings each year. The table above shows our estimates (based on published accounts) of the number of years each LIC could retain its current dividend payments without generating any additional profits. This is a good indicator of dividend sustainability when markets turn down.

Coverage of one means that an LIC could maintain its current dividend payout for one year without generating any profit in the current year.

Contango MicroCap dividend could be at risk of a cut

The highest yielding LICs in our coverage universe are the two Contango Asset Management (ASX:CGA) managed LICs, Contango MicroCap (ASX:CTN) and Contango Income Generator (ASX:CIE) with yields of 7.0% and 6.6% respectively, albeit only 50% franked. Whilst CTN appears to have reasonable profit reserve cover of 1.8 years, we think this dividend may be under threat given poor performance of the portfolio. CTN has delivered negative portfolio returns of 11.3% and 1.7% p.a. on a one and three-year basis. Whilst performance has been positive in the last three months, we think the performance of recent years could prompt a dividend reduction.

Although CIE has slightly less coverage at 1.4 years, we think the dividend is more sustainable. It generated a 5.5% portfolio return on a 12-months basis and many of its portfolio holdings are in companies that deliver stable, relatively attractive dividends (in many cases fully franked) and can to be passed on to CIE’s shareholders.

Hunter Hall Global Value has the strongest cover

Hunter Hall Global Value (ASX:HHV) has undergone a period of significant turmoil since the departure of its founder, Peter Hall in December 2016. However, stability seems to have returned since the merger of its manager with Pengana Capital. Like CTN, HHV generated a significant portfolio decline in the past 12 months. However, the new manager has unwound most of the old portfolio and re-established the portfolio in accordance with its own processes, so hopefully some stability will return. We believe the new manager has stronger risk disciplines around the portfolio, so volatility of return should be reduced. Despite the poor portfolio performance over the past year, we think the fully franked dividend is reasonably safe given more than six years of profit reserve cover.

Whilst Asian Masters Fund (ASX:AUF) shows up with a high yield, we note that this is due to a special dividend payment of 5 cents per share in May 2017 versus ordinary dividends of 2.2 cents per share. The LIC doesn’t have a history of paying special dividends, so we would not be assuming further specials. The LIC does however appear to have good reserve coverage.

Westoz Investment Company (ASX:WIC) also has good coverage at 3.3 years. With this LIC exposed to the West Australian resources driven economy, its returns and earnings can be volatile. It performed strongly over the past year on a rebound in resources but the five-year portfolio return is just 3.3%. The full year dividend was dropped back from 9 cents per share to its current level of 6 cents per share in FY2016 and looks sustainable at that level for a time, unless there is another major downturn in resources. The board is targeting a dividend of 6 cents per share for FY2018.

At 3.6 years, WAM Research (ASX:WAX) also has strong dividend profit reserve cover. The LIC has been steadily increasing its dividends for a number of years and with a history of delivering strong portfolio returns we don’t see any immediate threat to the dividend. WAM Capital (ASX:WAM) has much slimmer reserve cover at 1.1 times, although we note that it too has a history of delivering strong portfolio returns and so is continuously generating new profits from which to pay dividends. However, the dividend could come under threat of a reduction in a severe market downturn.

Cadence Capital (ASX:CDM) had a good FY2017 with a portfolio return of 10.0%. However, it was one of the few LICs to reduce its dividend in FY2017 with the full year dividend of 8 cents per share down from 9 cents per share in the prior year. Dividend cover from profit reserves is just one year which doesn’t leave much in reserve in the event of a severe and prolonged market downturn.

Djerriwarrh Investments was another LIC to reduce its dividend payments in FY2017 due to lower dividend options income. The reduction had been well flagged. Whilst the outlook for DJW’s dividend income is slightly better, with 1.1 years of profit reserve cover, there is the risk of a further reduction in its dividend payments to shareholders if its own dividend income declines and/or volatility remains low.