The Diverse Income Trust — Weak sentiment presents exciting opportunities

The UK’s economic growth is slowing and leading economic indicators are trending downwards. Following a decade of economic expansion propelled by unprecedentedly low interest rates and abundant liquidity, a cyclical slowdown has been widely anticipated. However, geopolitical events, including Brexit and the ongoing US-China trade dispute, have exacerbated the magnitude and pace of the slowdown. The lack of certainty surrounding the terms of the UK’s future relationship with the EU has stymied investment and manufacturing activity has been contracting. In September, new export orders fell for the sixth consecutive month as European customers searched for alternative suppliers. Although policy responses may be deployed to manage the economic downturn, the impact of such measures may be limited given interest rates are still close to historic lows, and the government remains fiscally constrained. Geopolitical developments are likely to continue to influence the direction of markets for the time being. However, global asset managers’ allocations to UK equities are already at very low levels, significantly below that of 2008 and 2009 when the banking system was facing a systemic crisis. Furthermore, UK equities appear attractively valued relative to global equities. The chart on the front page shows that UK equities are trading on an 18% forward P/E discount to world market, and this discount has widened consistently and considerably since the EU referendum in June 2016. A reduction in Brexit-related uncertainties may help improve sentiment towards UK equities.

DIVI was launched in April 2011 and aims to provide shareholders with an attractive level of dividends as well as capital growth over the long term, through investing mainly in UK equities. The trust is not constrained by index considerations and is able to invest across the market cap size spectrum, giving the managers a very wide opportunity set from which to select stocks. The managers, Gervais Williams and Martin Turner, are smaller company specialists who focus on firms that are able to sustain strong cash flow, which in turn can underpin long-term dividend growth. They often find attractive investments among smaller firms, less well-researched firms with niche market positions, which the managers believe offer genuine diversification from the sectors that dominate mainstream indices. As at end-September 2019, the portfolio held 138 stocks, of which over two-thirds of the portfolio was invested outside of the FTSE 350. The remainder of the portfolio is invested in mid- and large-cap stocks that tend to be very liquid. The managers are also mindful of downside risk and have invested in a FTSE 100 put option, which effectively acts as an insurance policy covering the portfolio against a sharp fall in UK equities.

Williams observes that the environment for UK equities is weak. Slowing growth, less favourable liquidity conditions and very poor investor sentiment caused by Brexit have weighed on UK stocks. Against this backdrop, he believes that DIVI is well placed to deliver premium returns over the long run. The fund’s prospects are assisted by its wider investment universe, giving the managers more choice to seek quality companies that are less well discovered. Williams highlights that small-cap companies are disproportionately out of favour; however, there is room for valuations to normalise, especially post a Brexit agreement. Furthermore, he is focused on companies that generate a good and growing yield at a time when large-cap companies listed on mainstream indices are showing declining levels of dividend cover, and he notes that several widely held high-yield stocks have already cut dividends (for example Vodafone, BT and Marks & Spencer). Williams believes that the abundant liquidity and synchronous global growth that provided the backdrop for equities for most of the past decade, has been most favourable for large growth stocks. In his view, many sectors within the mainstream indices are often duplicated across the developed markets, and investors’ portfolios are highly correlated to one another, which leaves them at risk of earnings and dividends disappointments. He believes that DIVI’s active share of c 88% relative to the FTSE All-Share Index, and its multi-cap approach, offer investors genuine diversification benefits.

DIVI employs a disciplined, bottom-up approach to selecting companies, typically based on their cash flow payback on their capital expenditure and the potential to pay an attractive and growing dividend over three to five years. Meeting companies and gaining confidence in their governance and management is important, especially as the managers often find the most interesting opportunities among firms that widely overlooked and require proprietary research. The managers have a long-established framework for evaluating the attractiveness of a company:

Exhibit 2 shows DIVI’s portfolio exposures by sector as at end-September 2019. The most significant change over the past year has been a significant increase in cash, which has risen to 6.9% of the fund from 1.9% a year ago. This has mainly reflected a high number of portfolio companies being taken over, which Williams believes highlights the undervaluation of many UK mid- and small-cap firms. Furthermore, he notes these takeovers have enhanced the liquidity of the small-cap element of the portfolio. Holdings that have been acquired include payments technology company Safecharge, communications services provider KCOM, and most recently in September 2019, insurance services firm Charles Taylor. The increased level of cash also reflects the divestment of some holdings where the investment case has matured and, in the manager’s view, their share prices presented attractive selling opportunities. Gift stationery supplier IG Holdings and litigation finance company Burford Capital are examples of this category. DIVI has been gradually reducing its stake in Burford over the past three years and had fully sold the position ahead of its share price collapse in August. The generous cash position as at end-September 2019 does not reflect a bearish stance; rather, the managers say they are finding plenty of attractive companies, which they think are currently trading on depressed valuations and present long-term investment opportunities.

DIVI has been in reinvestment mode, reflected in a number of new purchases and additions in recent months. These include a new position in mineral sands mining company Kenmare Resources. The company operates three mines in Mozambique and its main product is merchant ilmenite, a feedstock of titanium dioxide, of which it the world’s largest producer. Titanium feedstocks are used as pigment to impart whiteness and opacity in paints, plastics and paper. Global consumption for pigment is growing, driven by emerging markets as rising incomes and urbanisation fuel demand for higher-quality consumer products. Williams believes the company is nearing the end of a capital expenditure cycle, which will upgrade capacity and production efficiency, reduce unit costs and expand margins. He expects Kenmare to move into the cash payback period for its investments and to start paying dividends by the end of 2019.

The manager has also invested in three online financial trading companies, IG Group, CMC Markets and Plus500. Williams identified that these stocks tend to do well at times of rising stock market volatility. Furthermore, DIVI was able to purchase these companies at low valuations, at a time when their trading was adversely affected by new regulations required for their private clients. This disruption has now stabilised, meanwhile Williams notes that these firms’ hedging costs have fallen as their clients’ positions are less geared than they were in the past, which he believes should be positive for profitability.

The managers have also introduced another AIM stock, iEnergizer, into the portfolio. The company is a global business process outsourcing (BPO) solutions company based in India. It offers a broad range of outsourcing services across many industries, including banking, healthcare and legal. Williams thinks the company has a strong market position and management, noting the firm’s high customer retention and robust balance sheet. iEnergizer has been reducing and refinancing its debt, which combined with good operating cash flow generation, should support growing dividends. At the time of purchase, the stock offered an attractive 6% yield.

DIVI has also purchased claims management and specialist accident services company Redde (also AIM-listed). The stock was one of the top 20 companies held in Woodford Equity Income Fund. The suspension of this fund resulted in a sharp fall in share prices of its underlying holdings and in Williams’s view, Redde’s valuation became unjustifiably and artificially depressed. The manager believes Redde has a solid business model, generating strong cash flows and returns, which he thinks can sustain its generous dividend yield. At the time of purchase, Redde traded at a dividend yield of over 10%.

As shown in Exhibits 4 and 5, DIVI’s NAV total return has outperformed the FTSE All-Share, FTSE 350 High Yield and FTSE Small Cap indices over five years and by a considerable margin since its inception in April 2011. Since inception, the trust has delivered an annualised NAV return of 11.5%. Nearer-term DIVI’s NAV performance has generally lagged although it has outperformed the FTSE Small Cap Index in all periods shown. Over the past three years, a narrow set of large-cap FTSE 100 multinational stocks have outperformed, benefiting from a sharp fall in sterling after the UK’s EU referendum and a recovery in commodity prices. Conversely, smaller companies have been increasingly out of favour. As shown in Exhibit 4 (LHS), DIVI’s NAV performance year to date has been relatively stable against a more volatile UK equity environment. The multi-cap strategy is significantly differentiated from the mainstream indices, which means relative performance can diverge meaningfully.

The board aims to keep DIVI’s discount to cum-income NAV at a sustained, low level, subject to market conditions and historically, the trust has traded close to its NAV with brief exceptions. During FY19, the trust had an average discount to NAV of 0.3% and the board is aware that this has widened more recently and that DIVI has traded below NAV for some months. This partly reflects the significant outflows from UK equities against a challenging geopolitical and economic backdrop, with small- and micro-cap stocks being particularly out of favour. There is scope for the discount to return to its historic norms on improved sentiment for UK equities. The board has the authority (renewed annually) to buy back shares if it considers it to be in the best interests of the shareholders.

DIVI is a conventional investment trust with 378.3m shares in issue. The trust has an annual redemption facility that allows shareholders to voluntarily tender their shares at NAV less costs on 31 May each year. Redemption requests must be received by 30 April. For FY19, 5.5m shares, representing 1.4% of issued share capital, were repurchased and cancelled at a price of 95.39p per share (FY18: 0.5m shares were repurchased representing 0.1% of issued share capital). The board has recently agreed a reduction in the management fee payable to Miton Trust Managers. With effect from 1 August 2019, an annual fee of 0.9% is payable on the average market cap of the company up to £300m; then 0.8% on the average market cap between £300m and £600m; reducing to 0.7% above £600m. Previously, the first tier was applied at 1.0% and 0.8% was applied on all assets above £300m; the third tier was introduced on 1 August 2019. These fees are charged to both the income and capital accounts, allocated at 75% and 25% respectively. For FY19 the ongoing charges were 1.16% (FY18: 1.13%). Gearing is permitted up to 15% of NAV and the trust has a £25m loan facility with the Royal Bank of Scotland. As at 30 September 2019, this facility was unused and the trust held net cash of 6.9%.

DIVI’s primary objective is to pay shareholders a good and growing dividend income. The trust has consistently grown its regular dividends since launch and has also paid special dividends when it has had abnormal one-off receipts during the financial year. Over the past eight years since listing to end-May 2019, the dividend paid to shareholders has grown by a compound 8.8% pa. For FY19 DIVI’s ordinary dividend of 3.65p per share represents a 7.4% increase over the previous year. The board has also recommended a special dividend of 0.16p per share (FY18: 0.23p). Revenue reserves continued to increase by £0.8m to £17.5m as at end-May 2019, which allows the board flexibility to smooth future payments in the event of a temporary fall in portfolio income.

DIVI is a constituent of the AIC UK Equity Income sector, which consists of 24 funds. Exhibit 9 shows the 12 largest funds in the sector, among which DIVI is the smallest by market capitalisation. Many of the peer group funds are large-cap focused, whereas DIVI is biased towards small-caps which have performed less well over the past three years. The trust’s NAV total return ranks ninth over one and three years and fourth over five years. Over these periods, its returns have been generated without the use of gearing. DIVI’s dividend yield of 4.2% is close to the peer average; however, it ranks eighth in this group of income-focused funds. The trust has the highest ongoing charge, which partly reflects its smaller size but also, in the manager’s view, the labour-intensive nature of running a multi-cap fund with considerable weighting in small- and micro-cap companies.

DIVI’s board currently consists of five independent non-executive directors. It recently announced the appointment of Michelle McGrade with effect from 10 October 2019. McGrade has broad experience across the investment management industry, including asset management and private wealth. She is also a non-executive director of M&G Securities and an adviser to the investment committee of the Sainsbury’s Pension Scheme. DIVI’s current chairman, Michael Wrobel, has announced his intention to retire at the 2020 AGM, having served on the board since its inception in April 2011. The other directors and their dates of appointment are Paul Craig (April 2011), Calum Thomson (December 2016), Andrew Bell (January 2019) and Caroline Kemsley-Pein (January 2019).