The Diverse Income Trust — Managed for sustained dividend growth

A long period of strong market returns in the UK has been supported by a remarkable reduction of 10 year gilt yields, falling from 10% in 1992 to just 1% currently. Lower bond yields have pushed up the value of assets and the FTSE All-Share index level is near an all-time high, commanding a current P/E of c 25x. Meanwhile, dividend cover has fallen towards this century’s lows as larger companies’ share prices have been rewarded for yield ahead of capital reinvestment. With central banks around the world looking for the appropriate opportunity to shrink balance sheets, equity market conditions may become less favourable.

DIVI’s managers believe, going forward, smaller companies have brighter prospects than mainstream listed companies and that they can perform much better in economically challenging times. By virtue of size, they can be more nimble and, because they are less researched by institutions, are also less well-owned by institutions. This theory seems to be supported by recent performance. For the year to end September 2017, the FTSE Small Cap index has increased 17.8%, ahead of the 11.9% gain for the FTSE All-Share index.

DIVI was launched in April 2011 to invest in UK companies across the market capitalisation spectrum, unconstrained by benchmarks. This approach allows the managers to access a much larger opportunity set compared with typical UK equity funds. The primary objective of the trust is to pay shareholders a good and growing income, principally derived from those dividends received from its portfolio companies. This, in turn, should also support attractive capital growth over time.

DIVI is managed by Gervais Williams and Martin Turner at Miton Asset Management (where Williams is also managing director). Both are smaller companies specialists who believe the better investment opportunities often lie outside of the largest stocks, which are well-researched and highly correlated with the overall market. The trust therefore has a strong smaller-cap bias and, typically, over two-thirds of its holdings are outside the large and mid-cap FTSE 350 index. The portfolio is well diversified, with over 150 holdings across 12 industry sectors.

Williams and Turner also manage an equivalent open-ended fund (OEIC), Miton Multi Cap Income. Demand for the firm’s multi-cap income strategies has been strong. DIVI has grown from £50m assets under management at launch to c £390m through a combination of strong performance, share issuance and a merger with Miton Income Opportunities Trust in 2013, while the OEIC has grown to over £950m. The closed-end structure can be of benefit for a small-cap biased fund, as holdings can be illiquid. It also allows for gearing of up to 15%. DIVI has a borrowing facility in place, which is currently unused but enables the fund to be agile to invest at depressed levels when markets suffer setbacks.

Williams believes the current three-decade long credit cycle, extended by quantitative easing since 2008, has left markets too complacent about risk. He notes the expectation for FTSE 100 volatility is at the bottom of its range since 2008 in spite of elevated risks, and sees “very little cushion in the system”. Personal levels of debt are high while wage growth is stagnant. At the corporate level, productivity has been declining at the same time dividends have been rising (in response to shareholder demand for income), with the resultant dividend cover near all-time lows for this century. Central banks are looking to increase interest rates from current ultra-low levels, which would reverse the trend of abundant liquidity that has fuelled asset price rises. Meanwhile, there is little room for policymakers to manoeuvre with interest rates so low, alongside fiscal and political limitations.

The managers are attentive to downside risk and the protection of investors’ capital, focusing on stocks that are conservatively financed. Williams observes that small stocks outperformed significantly during the 1960s and 1970s in spite of extreme economic challenges (including high inflation, sterling devaluation and stagflation). Small companies are better placed to invest in slow-growth and more uncertain environments as many of the most attractive opportunities will be smaller in scale and thus of less interest to large companies. Dividends are still growing amongst many small stocks. Conversely, organic dividend growth for the FTSE All-Share index declined one percentage point in 2016, with the headline increase of 4.2% reflecting currency translation gains from a sharp fall in sterling.

The managers believe companies that can grow dividends consistently over time also tend to drive a sustained increase in share price performance. In particular, they are looking for companies that can improve productivity and generate attractive payback on invested capital. Such companies are best able to underpin future cash flow which, in turn, funds future dividend growth. In assessing a company’s potential prospects, the managers pay close attention to five key characteristics:

The all-cap approach to investing gives the managers a very large and diverse universe of around 1,600 companies from which to select investments for a portfolio of around 150 stocks. As part of its bottom-up, stock specific investment process, the managers meet 70-80 companies a month. Each investment candidate is then subject to rigorous analysis with particular focus on how it satisfies the five key characteristics described above. Similarly, when a portfolio stock show signs of weakening in these areas, it is flagged for potential sale.

As at 31 August DIVI held 152 holdings. This is significantly higher than UK equity income peers and reflects the fund’s bias towards smaller-cap stocks which are less liquid, necessitating smaller position sizes. Stocks outside the FTSE 350 accounted for 68% of the fund. The managers are not subject to benchmark nor sector constraints. As a result, the portfolio represents a set of stock-specific, high-conviction decisions, and can deviate significantly from the index (as shown in Exhibit 2).

The exhibit also shows sector exposures are little changed compared to a year ago. While the fund remains overweight consumer services relative to the FTSE All-Share index, much of this exposure is international stocks where the immediate challenges are less acute than those facing domestically-focused companies. The overweight positions to sectors such as industrials and technology are believed to be beneficiaries of the weakness in sterling.

The fund is underweight oil & gas, healthcare and consumer goods. The managers have been adding to the oil & gas sector more recently and hold stocks such as Shell and BP. At holding sizes of just 1% each, however, the fund remains notably underweight this sector relative to the index. Meanwhile, the managers find the current environment of high personal debt levels, stagnant wage growth and potentially higher interest rates unattractive for consumer cyclicals.

At the end of August, Stobart Group was the fund’s largest position despite some profit-taking. Although the stock has performed very strongly, the managers still consider the investment case for this stock to be compelling from dividend growth and valuation perspectives. They are also of the view that, in the smaller-cap space, there continues to be plenty of good investment opportunities, and they note improved primary issuance opportunities. DIVI has recently participated in several IPOs, including Strix and Arena.

Strix is the world’s largest kettle controls manufacturer with around 38% global market share, capitalising on changing consumer tastes in favour of teas, especially in the US. At purchase, the company traded on a single-digit PE. Arena is a global events management company operating in an immature market with good margins. Both companies are expected to generate attractive dividend yields.

FTSE 100 put option position

The managers are attentive to downside risk and use put options to help provide ‘insurance’ against a sharp setback in UK equities. The FTSE 100 put option position effectively allows DIVI to make gains if the index falls below 6,500. The gains will be proportionate to the scale of the market setback below this level and can be used to add holdings to the portfolio without the prior need to sell existing holdings at a time when stock prices are depressed. The duration of the option provides for ‘insurance’ to March 2019 and has an effective monthly cost of around 0.05% of the portfolio, which the managers believe is modest relative to its potential benefits.

DIVI’s NAV growth has outpaced the FTSE All-Share and FTSE 350 High Yield indices over all periods shown in Exhibit 4, and by 57.3% and 57.5% respectively since its inception in April 2011. This effectively shows outperformance against large-cap stocks as the FTSE 100 accounts for over 80% of the FTSE All-Share index. DIVI has also outperformed FTSE Small Cap Index over most periods. Williams notes that small-cap companies have traditionally been focused on growth at the expense of dividends, but this trend is in reverse and is contributing to an expansion of the trust’s investable universe.

DIVI currently trades at a narrow 0.2% discount to NAV (cum-income). The trust has traded close to its NAV since inception, often at premiums with the five-year and ten-year average premiums of 1.4% and 1.5% respectively. In part, this reflects strong investor appetite for the strategy, as evidenced by the strong growth in assets to over £950m for the equivalent OIEC, Miton UK Multi-Cap Income fund. The narrow discount is also a result of the fund’s ability to manage supply and demand imbalances through share issuance and an annual redemption facility.

DIVI is a conventional investment trust with 383.5m shares in issue. It listed in April 2011 with 100m shares and has grown significantly through C share issuance and a merger with Miton Income Opportunities Trust in 2013. DIVI operates a redemption facility whereby shareholders can elect to redeem their shares at NAV less costs on 31 May each year. Redemption requests must be made by 31 April. In FY17 the company received redemption requests for 1.1m shares, all of which were matched with buyers. Miton Trust Managers receives a management fee per annum calculated on the adjusted market capitalisation of the company of 1.0% for up to £300m and 0.8% above £300m. These fees are charged to both income and capital, allocated at 75% and 25% respectively. For the year ended 31 May 2017 the ongoing charges were 1.15%. The trust has an overdraft facility and is permitted to gear up to 15% of NAV. At end July 2017 the company was ungeared.

The primary objective of the fund is to grow dividends consistently over time. For FY17, DIVI declared ordinary dividends of 3.00p per share, an increase of 7.1% over FY2016. The board also proposed a bonus dividend of 0.40p per share reflecting the receipt of many special dividends from its portfolio companies over the year. Williams notes revenues from the portfolio over the past two years have risen faster than expected. Revenue reserves of £15.5m as at the financial year end more than covers the cost of the dividends declared (and the proposed bonus) and is available to help smooth distributions to shareholders in future years.

Dividends are paid quarterly in February, May, August and November.

Exhibit 7 shows the 12 largest peers in the AIC UK Equity Income sector, comprising of 23 funds. DIVI ranks third in the sector for NAV total returns over both three and five years, and seventh over one year. Its yield of 3.0% is at the lower end of its peers though consistent with the fund’s objective to provide good and growing dividends rather than simply high yield. DIVI’s ongoing charges are above average though, unlike some peers, there is no performance fee. It is one of four funds trading on a premium to ex-par NAV, whereas the peer group average is a discount of 3.8%.

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