The Diverse Income Trust — Long-term dividend and capital growth

UK equities have performed strongly since the start of 2016 reaching a peak in January 2018 on the back of accelerating global growth, and a prolonged period of unprecedentedly low interest rates. Prompted by extended valuations and the prospect of interest rates rising faster than expected, the FTSE 100 has retreated around 10% from this peak. This has helped moderate valuations, although global growth and earnings prospects remain supportive. However, volatility has increased from 2017’s exceptionally low levels when the VIX volatility index averaged 11 – almost half the 20-year average of 20. The rise in market volatility suggests investors have become more sensitive to risk, and the recent trend of more volatile markets may persist.

DIVI was launched in April 2011, with the primary objective to provide shareholders with a good and growing dividend income. This is achieved through a strategy that focuses on companies selected for productivity improvement, where strong cash flow can underpin growing future dividends, and are conservatively managed with robust balance sheets. The fund is not constrained by a benchmark and can invest across the market capitalisation spectrum, primarily in the UK, to allow the managers a wider opportunity set from which to select stocks. The managers, Williams and Turner at Miton Asset Management (where Williams is also senior executive director), are smaller companies specialists, who believe better investment opportunities lie outside of the larger, mainstream stocks, which are well researched and well owned. Therefore, DIVI has a strong small-cap bias and around two-thirds of the portfolio’s holdings are outside the FTSE 350 index. Risk is mitigated by investing in a diversified portfolio, typically between 80 to 160 securities, predominantly in smaller position sizes of no more than 1.5% of the fund at the time of purchase.

Williams and Turner also manage an equivalent open-ended fund (OEIC), Miton Multi Cap Income, which has assets of over £1bn, reflecting strong demand for their all-cap strategy. DIVI’s closed-ended investment trust structure is well suited to a small-cap biased fund, as holdings can be illiquid. Gearing of up to 15% of NAV is permitted and DIVI has a borrowing facility in place, which is currently unused but enables the managers to be agile and invest when stock markets suffer significant setbacks.

Williams believes globalisation since 1990 has been a significant driver of world economic growth, supporting a very positive period for corporate profitability. At the same time, low-cost imports have suppressed inflationary pressures and falling bond yields have lifted returns on asset classes in general. This environment has led to many funds aligning their investments with mainstream indices and, as a result, many savers are now overweight a narrow range of stocks, carrying elevated stock-specific risk. The manager is not surprised by the recent increase in volatility, and while the market has become more risk aware, Williams has not as yet observed significant changes in investor behaviour. The DIVI investment strategy has been designed to deliver returns from factors that differ from mainstream drivers, and the managers are “remarkably upbeat” that it can do well in the current environment, and note:

DIVI seeks to generate an attractive level of dividends, coupled with capital growth over the long term. It is benchmark agnostic and looks across the market capitalisation spectrum for opportunities. The approach is bottom up and draws on the considerable experience of the two portfolio managers, Williams and Turner, and the broader Miton investment team. Meeting companies and their management teams is a key part of the investment process and the managers conduct 70–80 meetings a month, which are followed up with rigorous fundamental analysis. The managers believe companies that can deliver productivity improvements have the best chances to grow cash flow and dividends in the future. Five factors help identify such companies:

As shown in Exhibit 2, over the year to end February 2018, the biggest changes to the portfolio are reduced exposure to the consumer discretionary sector (-4.9pp) and increased exposures to the energy (+4.5pp) and materials sectors (+3.7pp).

The manager has held a negative view on the outlook for UK consumption for some time, given high levels of consumer debt, and the prospect of rising interest rates. A number of positions were sold, including troubled company Conviviality, which the investment process also flagged as having uncomfortable levels of debt. The majority of DIVI’s position was sold prior to the share price peak, with the final scrap sold after the profit warning. The consumer discretionary sector can still present attractive investments and top 10 holding, wrapping paper design and manufacturer IG Design, has been a strong performer. It operates in an industry with just three leading global players, which implies their margins may be less vulnerable than others where the competitors are more numerous.

The synchronous pick-up in global growth last year led the manager to expect rises in oil prices and other commodities. The increase in materials exposure includes purchases of gold-related companies (Polyus, Highland Gold and Centamin), which were attractively valued and paying good dividends. They also serve as proxies to the gold price, which has a low correlation to the broader equity markets. The higher materials exposure also reflects strong performance from the largest holding in the sector, Zotefoams, a world leader in cellular materials technology used in a broad range of industries from aerospace to athletic footwear.

In the energy sector, additions include BP, Shell and Savannah Petroleum. The manager says the oil price bottomed in early 2016, while global growth has helped bring supply and demand into balance. Supply pressures, however, could develop as major oil companies made severe cutbacks to their investment plans after the oil price collapsed in 2014. Meanwhile, Venezuelan production looks at risk, and geopolitical risks, such as tense US–Iran relations, continue.

DIVI has also recently invested in Iceland, which accounts for around 3% of the portfolio. In the aftermath of its financial crisis of 2008, the Icelandic government put its failed banks into receivership and liquidation, and policies were put in place to encourage a reduction in corporate and consumer debt. As a result, the economy has recovered relatively quickly and is now in robust financial health, well placed to support a new growth cycle. Capital controls were lifted in March 2017, allowing foreigners to invest in Iceland. William believes there are attractive, relatively undiscovered companies, with strong balance sheets and high yields in this market. He also notes its benefit of low correlation to major stock markets; during the sharp global sell off in early February, Icelandic stocks showed relative resilience.

The manager is attentive to downside risk and use a put option to help protect the portfolio from a sharp fall in mainstream market values. This asset brings the right to sell the FTSE 100 Index at 6,500, and in the event of a major market setback below this level, the cash proceeds could be used for additional purchases at a time when share prices are depressed. In December 2017, the manager took advantage of very low market volatility to extend the option term from March 2019 to September 2019, at an attractive cost covering c 40% of the trust, which compares with c 33% this time last year. The cost of this option remains less than 0.1% of NAV per month on average, were the option to expire worthless at the end of its term.

As shown in Exhibit 4, DIVI’s share price and NAV total returns have outperformed the FTSE All-Share, FTSE 350 High Yield and the FTSE Small-Cap indices over all periods shown. Over the longer term, the outperformance is most pronounced against the mainstream FTSE All-Share and FTSE 350 High Yield indices, although over five years and since inception, DIVI’s performance has also convincing outpaced the FTSE Small-Cap index.

DIVI is currently trading at a 0.7% to cum-income NAV, below its five-year average of 1.0%. As shown in Exhibit 6, the trust has traded close to its NAV over the last five years, although has spiked downwards during sharp market sell offs, such as following the UK’s European referendum and US presidential election results. DIVI’s shares trading close to NAV reflects a strong appetite for the investment strategy, as evidenced in the growth in assets to over £1bn for the equivalent OEIC, Miton UK Multi-Cap Income fund. It also reflects the board’s commitment to discount management through an annual redemption facility and the ability to issue new shares.

DIVI is a conventional investment trust with 383.5m ordinary shares in issue. Miton Trust Managers is paid an annual management fee of 1.0% up to £300m market capitalisation, reducing to 0.8% above this level. Fees are charged to both income and capital, allocated at 25% and 75% respectively. For the financial year ended May 2017, ongoing charges were 1.15%. Gearing is permitted up to 15% of NAV and the trust has a £25m debt facility with The Royal Bank of Scotland, with scope in certain circumstances to raise this to £50m. As at end February 2018, DIVI was ungeared and had a net cash position of 3.2%.

Dividends are paid quarterly in February, May, August and November. Since inception in April 2011, DIVI has increased ordinary dividends each financial year. In FY17 DIVI paid ordinary dividends of 3.00p per share, an increase of 7.1% over FY16, along with a special dividend of 0.40p per share, reflecting the abnormal number of special dividends received from the portfolio in the period. As at 30 November 2017, the trust held revenue reserves of £15.2m, which comfortably exceeds the £12.7m cash cost of the four ordinary dividends. The revenue reserves are available to help smooth distributions to shareholders in future years.

Year to date in FY18, DIVI has declared first and second interim dividends of 0.75p and 0.80p respectively, representing an increase compared with the first and second interim dividends in FY17, both 0.70p.

Exhibit 7 shows the 12 largest trusts in the AIC UK Equity Income sectors (which comprises a total of 23 funds). DIVI’s NAV total return ranks second over one and five years, and third over three years. It is notable these returns have been achieved without the use of gearing in rising markets, which is deployed by most of the peer group. Reflecting the more specialist nature of the strategy, it has the highest ongoing charge, although no performance fee is payable. Ranking second, DIVI is one of four trusts that are trading at a premium to ex-par NAV. Its dividend yield is lower than the average although this is consistent with the trust’s objective to provide good and growing dividends, rather than simply high yield.

DIVI has five independent directors, four of whom have served on the board since the trust’s inception in April 2011: chairman Michael Wrobel, senior independent director Jane Tufnell, Paul Craig and Lucinda Riches. Calum Thomson was appointed in December 2016 and is chairman of the audit committee. The directors have broad-ranging backgrounds in audit, fund management and investment banking.