Diverse Income Trust (The) — Managers see relative upside in any environment

According to DIVI’s managers, UK fund outflows have continued into 2023, having been a feature of the UK market over the past two years. This is despite mainstream UK equities having been the best performing developed equity market over the last two and three years in US dollar terms. However, this year international investors have modestly increased their allocations to global equity income stocks, including those of UK-listed businesses, which has supported the domestic stock market. Unfortunately, overseas investors do not have an appetite for AIM-listed equity income stocks, therefore UK fund outflows have continued to put pressure on this area of the market, as evidenced in year-to-date performance. The UK market is broadly flat, while the AIM index has declined by a further 18%.

Rising interest rates tend to negatively affect economic activity, with a lag. Hence, if the US and UK employ a ‘higher for longer’ approach to monetary policy, the chance of a recession increases. In addition, elevated energy prices are adding to cost pressures for both corporates and consumers. This scenario is not reflected in the latest Bank of America Global Fund Managers survey, which suggests that investors are hopeful that central banks will cut interest rates, as 64% of respondents are expecting a ‘soft’ or ‘no’ economic landing. If this outcome proves to be correct, then there is potential for markets to broaden out and investors to move down the capitalisation spectrum.

Williams and Turner see significant opportunities in AIM-listed equity income stocks given the wide valuation gap between these and those of UK large-cap companies. In addition, they comment that the whole UK market looks very attractively valued in both absolute and relative terms. The managers believe that once UK stocks come back into favour, there is potential for a multi-year period of outperformance. They note that UK equities have proved relatively resilient this year during a period of rising government bond yields. Williams and Turner talk about the possibility of a UK stock market ‘supercycle’ as global investors increase their low-beta exposure, and UK fund outflows turn into inflows.

The managers believe that, given their significant underperformance over a multi-year period, AIM stocks should be the prime beneficiaries of a change in UK fund flows due to their very inexpensive valuations; even modest inflows of new cash could have a significant positive impact on small-cap share prices. Williams and Turner discuss the virtuous circle of thriving small businesses – creating local employment, increasing productivity and putting more money in voters’ pockets – while they also have more straightforward tax positions (less potential for avoidance). The benefits of a thriving small business economy are being debated with a proposal for part of annual ISA allowances to be ring-fenced for investment in UK-quoted companies. If this were to be approved, the managers consider it could be a ‘game changer’ for the performance of the UK stock market, including small caps; they point to the solid outperformance of AIM-listed income stocks following the global COVID-19 pandemic.

Williams and Turner highlight the long-term outperformance of UK small-cap stocks compared with the broad UK market. So if, as they believe, UK large-cap stocks continue to outperform their global peers, then UK small-cap stocks should outperform global markets, which, optimistically, they suggest could last 10 or 20 years. The managers believe that the combination of low valuations and low institutional ownership creates a very favourable environment for the outperformance of UK small-cap stocks. They acknowledge there is a slim chance that central banks could return to ultra-low interest rate policies, which could drive up the valuations of a broad range of asset classes, but if this were to happen AIM-listed income stocks should also benefit. DIVI is also well-positioned if there is a significant market pullback this year as its large-cap index put option, which expires in mid-December 2023, covers around half of the portfolio value.

Exhibit 2 shows DIVI’s upside/downside capture over the last 10 years versus the Numis Smaller Companies excluding Investment Companies Index. The fund’s portfolio return is defensive with an upside capture of 66% and a downside capture of 54%. This low volatility, coupled with the trust’s long-term outperformance implies that DIVI offers investors a fund with an attractive mix of high alpha and a below-average beta.

DIVI has diverse exposure across the market cap spectrum (Exhibit 3). An important benefit of a multi-cap approach is to identify overlooked companies at the lower end of the market cap spectrum. At the end of August 2023, large and mid-cap stocks made up 37.3% of the portfolio. The (-8.6pp) lower weighting in AIM stocks was primarily due to their poor performance.

Exhibit 4 shows DIVI’s sector exposures, which have been rebased without cash. The largest differences versus the UK market’s sector exposures at 31 August 2023 were above-market weightings in financials (+11.3pp) and materials (+6.2pp), with a lower allocation to consumer staples stocks (-9.3pp). Since the trust’s inception in 2011, financials has always been DIVI’s largest sector; it is made up of a broad range of different businesses.

At end-August 2023, DIVI’s top 10 holdings made up 19.9% of the fund, which was broadly in line with 20.4% a year earlier; two positions were common to both periods. Over the period, the total number of holdings declined from 130 to 118.

DIVI has a large-cap index put option (c 0.1% of the portfolio) that currently extends to December 2023 and is significantly out of the money. 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 the event of a market crash, the managers estimate that the put option covers half of the value of the portfolio.

Data from the trust’s annual report show that since DIVI’s launch in April 2011 until end-FY23 (May), its NAV total return of +175.1% was significantly ahead of the Numis All-Share Index’s +89.4% and the Numis Small Cap plus AIM (excluding investment companies) Index’s 87.5% total return.

DIVI’s relative returns in Exhibit 8 show its long-term NAV outperformance versus Numis indices. Considering the trust’s more recent underperformance versus the broad UK market, DIVI has been particularly negatively affected by the wide divergence between large and small-cap stocks. As an example, in the last five years the AIM index fell by c 31% versus a rise of around 8% in the value of the UK largest 100 company index (at end-August 2023, more than 50% of the trust’s portfolio was made up of AIM and small-cap stocks).

Year to date, stocks that have detracted from DIVI’s performance include Strix Group, which is a manufacturer of kettle safety controls and other components. Its cash flow came under pressure following a 2022 acquisition and the position was sold. CMC Markets and Vanquis also had disappointing trading statements but remain in the portfolio as these companies are generating strong cash flows and the managers expect their businesses will improve.

Stocks that have contributed positively to the trust’s performance this year include DWF Group and STM Group, both of which received takeover bids, while Galliford Try Holdings (construction company), XPS Pensions (employee beneficiary consultant) and Yü Group (supplier of energy and utility solutions) had positive trading updates.

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 3.6%, which compares to an estimated 5–7% per year in normal market conditions.

In FY23 (ending 31 May), DIVI’s revenue return per share was 4.05p, which is 2.5% higher than its pre-pandemic level. This contrasts with the broad UK market, whose income in May 2023 was 10% lower than in May 2019. The trust’s annual dividend of 4.05p per share (1.0x covered) was 3.8% higher than 3.90p per share in FY22. During FY23, DIVI’s revenue reserve increased by 1.3% to c £15.2m, which is c 1.3x the annual dividend payment. Recently, the board declared a first interim dividend of 1.00p per share in respect of FY24, which is 5.3% higher year-on-year. It expects to at least maintain the total FY24 dividend at 4.05p per share, using revenue reserves if required.