Diverse Income Trust (The) — Delivering on its income and growth mandate

In the UK, there are a series of mature, slower-growth businesses that are capital intensive and a large part of their total returns have come from income. Since 2000, there has been limited capital appreciation in the UK market; the growth has come from the compounding of income. If inflation continues to be a problem and interest rates remain elevated, company valuations could be pressured and mainstream indices such as the US S&P 500 Index could underperform. In such a scenario, the UK could see an increase in allocations from international investors, particularly given its relatively attractive valuation. The Datastream UK Index is trading at an 11.0x forward P/E multiple verses a 13.6x 10-year average. It is also at a 26.9% discount to the Datastream World Index, which is considerably wider than the 12.2% average discount over the last decade. Comparing the size of a company versus its price-to-book valuation, the UK is dominated by low price-to-book companies, suggesting plenty of scope for a positive re-rating of the UK market.

An important feature of the UK market is that it is home to many smaller listed companies. Data from the London Business School state that since 1955, large-cap stocks have outperformed bonds and cash, small-cap stocks have outperformed large caps, and microcaps, which are the smallest 2% of companies (rebalanced every year), have outperformed the most. With the UK market having underperformed for the last 30 years, if it is harder to generate returns from equities, small caps could outperform.

As shown in Exhibit 1, DIVI has diverse exposure across the market cap spectrum. Large and mid-cap stocks combined make up just a third of the portfolio. Over the 12 months to end-May 2023, there were some notable changes in the trust’s market cap breakdowns, with a 9.3pp lower weight in AIM stocks due to poor performance and a 7.7pp higher cash weighting reflecting the managers’ near-term caution.

Part of the higher cash balance is the proceeds of DIVI’s iEnergizer position, which was a relatively large holding. The company offers answering machine services in Mexico and India and was trading very well and had a large cash balance. According to Williams, iEnergizer’s valuation was ‘trivial versus its prospects’; however, the company’s CEO owned more than 80% of the company and decided to delist the business. Also, profits have been taken on some of the trust’s larger positions including Mears Group, XPS Pensions Group and Man Group.

DIVI invests in a wide range of businesses and sectors, in both international and domestic opportunities. There are companies with the ability to thrive during challenging periods. An important benefit of a multi-cap approach is to identify overlooked companies at the lower end of the market cap spectrum.

At end-May 2023, DIVI had 126 holdings diversified across all 11 market sectors. Exhibit 2 shows DIVI’s sector exposures, which have been adjusted, taking into account the trust’s 11.5% cash weighting. Meaningful divergences between DIVI’s and the UK market’s sector exposures are above-market weightings in financials (+8.2pp) and materials (+7.1pp), with lower allocations to healthcare (-10.5pp) and consumer staples stocks (-8.1pp). Since the trust’s inception in 2011, financials has always been DIVI’s largest sector but within this classification there is a broad range of subsectors.

At end-May 2023, DIVI’s top 10 holdings made up 18.2% of the fund, which was a lower concentration versus 21.1% a year earlier; just three positions were common to both periods.

DIVI has a large-cap index put option (c 0.3% of the portfolio) that currently extends to December 2023. While in a rising market the value of the put option tends to become worthless as it approaches its expiry date, in a market pullback the value of the put option rises, which helps to offset the price declines of other portfolio holdings.

In recent months, DIVI’s portfolio activity has been modest. The managers have been taking some profits and topping up certain positions. There were complete sales of the NatWest Group and Lloyds Banking Group holdings due to higher interest rates and less lending; it is tough for corporates and consumers to borrow, and depositors have been withdrawing funds. Following three US regional bank failures earlier in 2023, Williams is concerned that there could be more, including in Europe as banks are highly geared at a time when the financial world is under more stress. DIVI’s position in housebuilder Persimmon was sold on the expectation that interest rates will be higher for longer. The trust’s holding in US-listed gold miner Newmont Corporation was sold on concerns that the gold price is peaking. It was added to the fund to provide gold exposure from a quality operator, which was unavailable in the UK. The managers can invest in overseas companies (up to 20% of the fund) but this happens rarely.

DIVI has a new modestly sized new position in Trident Royalties, which funds mining companies into their production phase and then receives a royalty stream. The company has a much lower valuation than US-listed equivalent companies.

Williams believes that the UK can outperform international markets. Looking at the performance of the UK All-Share versus the S&P 500 (in constant currency terms), between 1965 and 1986 the UK outperformed during this inflationary period. Since then, the UK has underperformed as there has been a focus on growth stocks, particularly since the end of the global financial crisis, when interest rates have been artificially low.

The manager comments that inflation has been worse than expected, and imbalances due to moving away from globalisation could lead to persistent higher prices and interest rates, which is likely to have a more profound effect on the economy. Williams believes that the chance of a UK recession has increased. He suggests that the last 30 years have been a ‘summertime’ for global investors as they have not needed to change their behaviour as inflation has remained low. Quantitative easing and ultra-low interest rates have exacerbated poor capital allocation, low levels of productivity and the existence of more zombie companies.

Williams is looking forward to more of a ‘winter’ environment, during which the advantages of listed versus debt-laden private companies should become more significant and persistent. The manager adds that there can be a real upside from a recession as there is a greater chance of strong companies with excess cash being able to acquire assets at very attractive prices. He cites Next, which has acquired Joules and Made.com; Made.com’s market cap peaked at £775m but had declined to £3.4m when the company declared bankruptcy. Even if Next had to add £25m to Made.com’s working capital, essentially Next has acquired a £300m business (c 3.4% of its market cap) for c £30m. William explains that moving down the market cap spectrum, being able to acquire assets at depressed prices should provide an even larger incremental benefit. He says that there are advantages for firms that are quoted and even more so for being a small, listed company. The manager suggests that the more zombie companies that go to the wall the better, as the globalisation trend has meant that poor corporate management teams have survived.

According to Williams, open-ended investment company outflows are continuing ‘thick and fast’. He opines that there needs to be a government policy change as the UK has a higher cost of capital versus other countries, which is depressing UK company valuations. The fact that UK companies are starting to move their listings overseas to where the cost of capital is lower has the potential to become a big problem for the UK government, suggests the manager. He is concerned that, within global indices, the UK weighting is already modest, so a further reduction could make the UK irrelevant. Williams highlights that calls for lower costs of capital in the UK are gaining momentum and that, if this occurs, it could be an important positive driver for the UK stock market. The manager cites the importance of small UK growth companies in terms of local employment, increased productivity and overall domestic economic growth.

Williams cannot believe the negative performance dispersion between the AIM and the UK large-cap indices. The AIM index has devalued due to redemptions and international investors have favoured UK large caps due to their low betas and high income, and it has also underperformed since the AIM market launched in 1995. Some of the IPOs were not justified; for example, many technology companies that listed during the dot.com boom subsequently failed. In the 2005–06 commodity bull market, some early-stage mining companies listed on AIM and during the global financial crisis these businesses were starved of cash, so they did not survive. The manager says that AIM is home to ordinary companies that are paying and growing their dividends; however, redemptions are putting pressure on their share prices, despite improving underlying operations. To provide a broader perspective, the Numis Small Cap Index has outperformed over the long term even during the 1960s and 1970s inflationary period.

There is a broad range of market caps in the AIC UK Equity Income sector. DIVI is one of the smaller companies, ranking 12th out of 20 funds. It has a differentiated approach by investing across the market cap spectrum from immature companies up to major, well-established multinational operators. DIVI’s broad stock list of more than 120 holdings means that it is not overly reliant on a small number of companies to fulfil its income requirement. Within the sector, only Law Debenture Corporation has a greater number of stocks in its portfolio, so most of DIVI’s peers have more concentrated income. Finsbury Growth & Income Trust, for example, is at the other end of the scale as its portfolio has around 20 names.

DIVI’s NAV total returns are solidly above average over the last decade, ranking fourth, but are below average over the other periods shown. The trust’s relative returns have been particularly negatively affected by the wide divergence between large and small-cap stocks. As an example, in the five years to 17 July 2023, the AIM index fell by around 31% versus a decline of around 3% in the value of the UK largest company index (at end-May 2023, c 50% of DIVI’s portfolio was made up of AIM and small-cap stocks).

On 17 July 2023, the trust’s 8.3% discount was wider than the sector’s average 5.4% discount; five funds were trading at a premium. Since launch, on average, DIVI has traded close to NAV. It has one of the highest ongoing charges, but its multi-cap approach provides lower-than-average volatility and a low correlation to equity markets. In line with its peers, no performance fee is payable. The trust was the only fund in the peer group not employing gearing, although it does have an undrawn facility available for use. DIVI’s dividend yield ranked ninth, which is around 20bp lower than the sector average.

Data from Premier Miton show that since DIVI’s launch in April 2011 until end-May 2023, its NAV and share price total returns of 175.1% and 147.7% respectively are significantly ahead of the Numis Small Cap plus AIM (excluding investment companies) Index’s 87.5% total return.

As shown in Exhibit 7, DIVI’s NAV is ahead of the UK market over the last decade but behind over the other periods shown. Considering the trust’s performance in the first six months of 2023, the largest detractors include: iEnergizer (delisted from AIM); i3 Energy (weaker oil price); Aferian (set-top boxes and software streaming, deferred customer orders but good future cash generation prospects; currently too small to attract investor attention); and CMC Markets (rolling out a new trading platform but not communicating the message effectively).

Stocks that have made a positive contribution to the trust’s H123 performance include: top 10 holdings Mears Group (provider of housing and social care) and XPS Pensions Holdings (pension consulting and administrative services – earnings upgrades and a growing dividend); along with Kitwave Group (wholesale distributor to convenience stores – May 2021 IPO on AIM); and AO World (electrical products retailer – business is getting back on track).

DIVI’s investment objective is to provide shareholders with an attractive and growing level of dividends coupled with capital growth over the long term. The trust’s revenue reserves have occasionally been used to supplement DIVI’s dividend payments in years when its income is reduced. Over the last five financial years, the trust’s regular dividend has compounded at an annual rate of 5.4%, which compares to an estimated 5–7% per year in normal market conditions.

In FY22 (ending 31 May), DIVI’s revenue return was £14.5m, while its total dividend payments were £13.8m (1.05x covered). At the end of the period, revenue reserves were £15.9m, which is equivalent to 1.15x the FY22 dividend payment. Revenue per share was 4.01p (+7.5% year-on-year), which was in line with FY19 (prior to the pandemic dividend cuts). The dividend per share was 3.90p (+4.0% year-on-year).

In H123 (ending 30 November), DIVI’s revenue return per share was 2.23p, which was a 1.4% increase year-on-year. At the end of the period, its revenue reserves had increased to £16.4m. So far, three interim dividends of 0.95p per share have been announced for FY23. These are 5.5% higher than the 0.90p per share first three dividends in FY22.

Portfolio company Galliford Try Holdings increased its FY23 interim dividend by 36.4% to 3.0p per share and has recently announced a 12.0p per share special dividend following the resolution of an industrial dispute. Other examples of higher dividends are top 10 holdings Kenmare Resources and Man Group, which increased their FY22 total distributions by 63.6% and 14.3% respectively.

DIVI’s 9.0% share price discount to cum-income NAV is wider than the 1.4% to 5.3% range of average discounts over the last one, three, five and 10 years. The trust is not unique in this respect as generally discounts have widened during a period of above-average investor risk aversion. There is considerable scope for DIVI to be afforded a higher valuation if investors become less cautious or there is an improvement in the trust’s relative performance. It should be noted that DIVI regularly traded close to NAV, at a premium as well as a discount, as recently as 2021.

The trust offers shareholders the option to redeem their shares each year. In FY23, c 37.3m shares (c 10.5% of the share base) were offered up and redeemed at 89.35p per share, which was the cum-income NAV at the close of 30 May 2023. The payment was made on 14 June 2023, so is classified as FY24 in Exhibit 12.

If the total redemption is sizable, although historically this has not been the case, the board can opt to create a redemption pool. This means that redeeming shareholders would receive the proceeds of the liquidated pool (which may take weeks or months to execute), rather than a payment based on the prevailing NAV at the close of the last working day before the end of May.

DIVI was launched on 28 April 2011 and is listed on the Main Market of the London Stock Exchange. Co-managers since launch, Gervais Williams and Martin Turner employ a multi-cap UK income and growth strategy seeking to deliver attractive returns by compounding good and growing dividends even in the absence of stock market appreciation. Williams is a renowned UK equity fund manager, whose passion for and experience of investing, along with his strong performance track record, make him an influential UK opinion leader. He joined Miton in March 2011 and is now head of equities at Premier Miton; Williams has been an equity fund manager since 1985. Turner joined Miton in May 2011 having qualified as a chartered accountant in 1992. The two managers have had a close working relationship since 2004 and bring complementary expertise to the partnership.

Williams and Turner have a bias towards investing in small- and mid-cap equities and the bottom-up stock selection approach means sector weights are a secondary consideration, and the portfolio does not track a benchmark index. However, the trust’s performance is measured against the Numis All-Share Total Return Index, which is the closest broad index available. Portfolio risk is mitigated by having a wide range of 100 to 180 holdings and at the time of acquisition, a single position may not make up more than 15% of the fund; most new holdings make up less than 1.5% of the portfolio. Derivatives can be used for efficient portfolio management, gearing and investment purposes. Uncovered short positions are not permitted. Unquoted companies are allowed, subject to prior board approval, up to 5% of the portfolio at the time of investment. Gearing via bank facilities and derivative instruments is permitted up to 15% of NAV at the time of borrowing.

Williams and Turner select stocks following thorough fundamental research, seeking companies that can generate sustainable cash flows to support growing dividend payments. Businesses that generate the largest long-term dividend growth are often those that also deliver the best capital growth. The bias towards smaller firms, which are often under-researched, increases the managers’ opportunity to find mispriced securities. They use a traffic light system (red, amber and green) to assess companies based on five key questions:

A deterioration in the grading of portfolio companies leads to a reassessment, and the holding could be sold.

DIVI is the only pure multi-cap fund within the AIC UK Equity Income sector. The trust’s managers are unconstrained by index considerations and have a very wide universe from which to source attractive opportunities. Many mainstream UK-quoted companies are relatively mature, so have surplus cash available to fund sustainable growing dividends. Some AIM-listed companies become dominant in their specific markets, enabling them to generate surplus cash and superior dividend growth. There are instances when a company’s long investment phase comes to an end, paving the way for substantial future cash flow and dividends. The managers also rotate out of companies that have appreciated significantly, resulting in a lower dividend yield; proceeds are reinvested into companies that are attractively valued and have dividend growth potential.

The board believes that integrating ESG into the investment process helps to achieve DIVI’s primary objective of delivering a good and growing level of dividend income. It supports the managers’ focus on helping UK quoted companies address the climate change agenda and encouraging them to deliver demonstrably socially useful outcomes. Williams and Turner use a variety of ESG information sources including companies’ reports and meetings with their management teams and boards, along with independent specialist ESG research and data, when available, to understand ESG-related risks and opportunities. There is generally more ESG information available for larger companies and while smaller businesses may have less robust ESG policies and disclosures, this does not necessarily reflect higher ESG risks. The managers are unable to invest in companies that are involved in banned weapons. When engaging with companies on ESG issues, Williams and Turner encourage discussion on a broad range of topics, such as remuneration, safety records, the use of staff surveys, board composition, working conditions in the plants of overseas suppliers and approaches to climate change.

DIVI has a revolving loan facility with the Royal Bank of Scotland International, London branch, of up to £5m (including an uncommitted accordion option of up to an additional £35m). The loan has an interest rate of 1.20% over SONIA on any balance drawn down, and a commitment fee of 0.45% and is subjects to covenants. DIVI has not employed gearing since the fund was launched.

Premier Miton receives a management fee of 0.9% per year on DIVI’s average market cap up to £300m, 0.8% per year of average market cap between £300m and £500m, and 0.7% per year of average market cap above £500m. The management fee is split 75%:25% between the trust’s capital and revenue accounts respectively. DIVI’s ongoing charges are higher than its peer-group average. The board considers this is justified in the context of the trust’s specialist investment universe and the premium returns that DIVI has generated since launch. The FY22 ongoing charges were 1.05%, which was 1bp lower than 1.06% in FY21. In H123, the estimated annualised ongoing charges was 1.08% (2bp higher year-on-year).

DIVI is a conventional investment trust with one class of share – there are c 318.5m ordinary shares in issue. Over the last year, DIVI’s average daily trading volume was c 370k shares.