Positioned to navigate more difficult conditions

After reaching a high of 7,103.98 in April 2015, the FTSE 100 index of leading UK shares has experienced significant declines, posting a negative total return of 6.5% for the 12 months to 31 January and a fall of 17.8% in points terms from its peak to the close on 3 February. The FTSE All-Share (about 80% of which is represented by the 100 largest companies) is also in negative territory over one year, but mid- and small-cap stocks have performed better, with the FTSE 250 and FTSE Small Cap producing total returns of 4.5% and 5.8% respectively over 12 months.

In volatile market conditions, dividends can make the difference between a negative and a positive total return. According to the Capita UK Dividend Monitor – a quarterly study of dividends from the largest 350 UK companies – UK dividends grew by 6.8% in 2015, excluding special dividends. However, the outlook is clouded by a supermarket price war eating into profits, and the effect of falling oil and commodity prices. While oil majors have maintained their payouts by cutting costs, Capita expects mining dividends to come under significant pressure in 2016, and forecasts a decline in underlying dividends for the UK in 2016 for the first time since 2010.

Dividends from mid-cap companies grew by much more than those of the largest companies in 2015, up 22.6% (15.3% excluding specials). Companies outside the largest 100 tend to be more exposed to the domestic economy, and this holds true for small- as well as mid-caps, suggesting the outlook for smaller-company dividends in 2016 may be rosier than for the market as a whole.

DIVI was launched in April 2011 to invest in UK companies across the market capitalisation spectrum, with the aim of achieving an attractive and growing income as well as capital growth. It is managed by Gervais Williams and Martin Turner at Miton Asset Management, a boutique fund manager of which Williams is also managing director. Both Williams and Turner are smaller-company specialists, and the majority of the DIVI portfolio is invested outside the large- and mid-cap FTSE 350, including in AIM and ISDX-listed stocks.

The managers also run an equivalent open-ended fund, Miton UK Multi Cap Income, as well as two less income-focused UK small-cap funds, the open-ended Miton UK Smaller Companies and the closed-ended Miton UK MicroCap trust. Demand has been strong for the multi-cap income strategy, with the OEIC reaching £585m of assets under management and DIVI having grown from £50m at launch to c £350m in less than five years, through a combination of performance, share issuance and a merger with the Miton Income Opportunities (formerly Henderson Fledgling) investment trust in 2013. The closed-end structure benefits DIVI as its permanent capital makes it better suited to holding very small companies, which may be illiquid, and it can also make use of gearing. In practice this has tended to be modest, and stood at 1.3% net at 31 December.

DIVI’s managers have long held the view that the credit-fuelled asset boom that was only briefly interrupted by the global financial crisis has effectively led to growth being ‘borrowed’ from the future. This means larger companies in particular will find it harder to grow, and suggests that diversification away from blue-chip stocks will lead to greater rewards for investors.

Recent market volatility has underlined concerns about world economic growth and in particular a deceleration in China, where Williams sees the current direction of monetary policy as a potentially serious error that could cause China’s currency to suffer similar falls to that of Brazil. This more uncertain outlook, coupled with the impact of commodity price falls on many large companies in the energy and materials sectors, could put pressure on dividends. The level of dividend cover has declined to c 1.5x for the FTSE All-Share index (at 2 February). DIVI’s dividend cover is c 2x, implying a dividend yield of c 4.5% on the portfolio given a median P/E ratio of 12-13x.

Williams points to a change in mood in the market, with the first interest rate rise in the US leading to an end of the ‘bad news is good news’ period, where investors saw any poor economic news as positive because it pointed to a continuation of ultra-low rates. By maintaining a focus on companies with growing cash flows and modest debt or net cash, and by ensuring the stock list is diversified by size and sector, the managers feel the DIVI portfolio is well equipped to weather such a period of negative sentiment. They also continue to hold downside protection in the form of a FTSE 100 put option (see below).

In December 2013 DIVI’s managers purchased a put option on the FTSE 100 index, which offsets risk for around one-third of the portfolio. Initially the option had a strike level of 5,800 and an expiry date of June 2015. In early 2015 as the blue-chip index neared all-time highs, the managers took advantage and extended the expiry date to June 2016, and did so again in early summer after the Greek debt deal caused a wave of investor optimism, with a new strike level of 6,000 and a March 2017 expiry. The cost of the option is c 0.06% of NAV per month.

In recent weeks the FTSE 100 has traded below this level, meaning the option is ‘in the money’, but Williams argues that it is right to keep the protection in place, comparing it with a car insurance policy that will only allow a single claim. While they could sell the option now, the managers are sufficiently cautious on the outlook for markets to hold on in case of a further, sharper market reversal, when selling the option would allow them to buy income-generating stocks at more attractive valuations than today. Should such a reversal not occur, DIVI will benefit from rising markets instead.

DIVI selects investments from a broad universe of c 1,600 companies across the whole UK stock market. The managers meet between 50 and 80 companies each month, and are broadly seeking stocks – regardless of size – that are paying attractive dividends that have the capacity to grow. (A new trust, Miton UK MicroCap, is more focused on higher-growth areas that do not yet offer compelling yields.) Williams notes that the decreasing research coverage of smaller companies (many small stocks are now only covered by their house broker) means there are more chances for a fund manager to spot under-appreciated opportunities. Candidates for inclusion in the portfolio of 100+ stocks are subjected to rigorous financial analysis, and the managers use a traffic light system (red or green) to assess companies based on five key questions:

The managers view companies with good and growing turnover, sustained or improving margins and little or no debt as those with the best risk/reward prospects. Any deterioration in these measures will result in the reassessment of holdings and could lead to stocks being sold.

Williams points to the multi-cap strategy as an important source of differentiation. While there might be 150 smaller stocks with attractive yields and prospects of dividend growth, of which 70 or 80 might make it into the DIVI portfolio, the ability to select from the 350 large- and mid-cap UK stocks as well gives the trust flexibility and means its portfolio has tended to have limited correlation with either mainstream equity income peers or pure small-cap funds.

At 31 December 2015 DIVI had 137 holdings in total, similar to the number six months previously but well ahead of the c 60-stock average for UK Equity Income peers. The length of the stock list is largely a function of DIVI’s focus on smaller companies (two-thirds of the portfolio is invested outside the FTSE 350). Williams explains that in the smallest companies it is not always possible to build a significant stake, owing to liquidity issues as well as the need to avoid overexposure; at the 30 November half-year 100 of the 137 holdings were positions of 1% or less. However, in an environment where growth is becoming more uncertain, the managers point out that there will be fewer companies that are able to continue to grow their earnings and margins, and a deterioration in market conditions would be likely to result in a shorter stock list.

In sector terms the portfolio is most heavily exposed to consumer services, industrials and financial services. Relative to the FTSE All-Share index the largest overweights are industrials, consumer services, insurance and technology. The biggest underweights are financial services, healthcare, oil & gas and consumer goods, which together make up 56% of the index but only 25% of the portfolio.

Recent changes include a fall in the insurance weighting following the takeovers of BRIT and Catlin; some of the proceeds have been reinvested in Phoenix Group but profits have been taken in Direct Line, which has performed well. The healthcare weighting is very small at 1.6% following the sale of holdings in GlaxoSmithKline and AstraZeneca, although the FTSE 100 weighting has risen over the past six months (from 10.3% to 15.4%), boosted by the purchases of easyJet and Taylor Wimpey. The blue-chip index has been the main source of turnover in the volatile markets of recent months.

The managers note a low level of IPO activity in 2015, with the run-up to the general election in the early part of the year and volatility from the summer onwards dampening appetite for flotations. One exception was low-cost accommodation booker Hostelworld, bought at IPO in October 2015 and now just outside the top 20 holdings. Outside the insurance sector M&A in the portfolio has also been subdued; the managers say many of the takeover premiums they have observed in the wider market are too low in the context of companies’ future growth potential, and they are engaging with holdings to discourage management from entertaining low-value bids.

DIVI has largely traded at a premium to NAV since launch, with a strong appetite for the strategy reflected in share issuance throughout its life (see Capital structure, below). At 9 February the shares traded at a 0.6% premium to cum-income NAV, which is below the averages of 0.8% over one year, 2.2% over three years and 2.1% since inception. A 12-month high of 5.0% was reached on 30 December 2015. Demand for the shares may be driven in part by capacity constraints for Miton’s multi-cap income strategy, leading to the soft-closure of the analogous open-ended fund.

DIVI is a conventional investment trust with 383.5m ordinary shares in issue. Having listed in April 2011 with 100m shares, it has grown significantly through C share issuance and a merger with Miton Income Opportunities Trust in 2013. DIVI operates an annual redemption facility whereby investors can redeem their shares at NAV minus costs on 31 May each year. Redemption requests must be made by 30 April and 2015 was the first year to see a net redemption under the facility, with 3.2m shares transferred to treasury. Miton Trust Managers is paid an annual management fee of 1.0% up to £300m market capitalisation, reducing to 0.8% above this. Fees and financing costs are charged 75% to capital and 25% to income. For the half-year ended 30 November DIVI’s ongoing charges were 1.18%. The trust has an overdraft facility and is permitted to gear up to 15% of NAV. At 31 December 2015 net gearing stood at 1.3%.

DIVI aims to achieve a sustainable and growing income rather than a high current yield, and as a result is one of the lowest-yielding trusts in its peer group (see below). Dividends are paid quarterly and from the current financial year are planned to be broadly equal in size. Previously the fourth quarterly dividend had been larger than the first three. As a step towards this rebalancing, five dividends were paid in respect of FY15, with what would have been the first interim dividend of FY16 redesignated as a final dividend. From the current financial year dividends will be paid in February, May, August and November, allowing shareholders to approve the final dividend at the AGM in October. The total dividend for FY15 was 2.9p per share (2.5p if the new payment calendar had applied). So far in FY16 two dividends of 0.65p have been declared; if the remaining two are paid at the same level the total dividend for the year would be 2.6p. Dividends were fully covered by income in FY15 and for the first half of FY16, and in four years of existence DIVI has built revenue reserves equal to c 80% of the current year’s dividend.

DIVI is a member of the AIC UK Equity Income sector. Exhibit 7 shows the 12 largest funds in the peer group of 23. DIVI ranks first of the funds shown below for NAV total returns over one and three years, and second in the whole sector over both periods. In terms of risk-adjusted performance as measured by the Sharpe ratio, DIVI ranks first over both one and three years. Ongoing charges are somewhat above average, although unlike some peers, DIVI does not charge a performance fee. DIVI’s premium to NAV places it towards the top of the sector, while gearing is below average. The trust has the second-lowest yield in the sector, although this should be viewed in the context of the trust’s intention to prioritise sustainable dividend growth over a high dividend yield.

DIVI has five directors. Chairman Michael Wrobel, senior independent director Jane Tufnell, Paul Craig and Lucinda Riches have all served on the board since the trust’s launch in April 2011. Tom Bartlam, the chairman of the audit committee, was appointed in October 2013. The directors have backgrounds in fund management, investment banking and corporate finance.