The Diverse Income Trust — Well-placed to capitalise on weak sentiment

Towards the end of 2019, the UK economy started to show signs of strengthening. A decisive election result, which cemented Boris Johnson’s position as prime minister, raised hopes for progress on Brexit, and, coupled with a de-escalation in the US-China trade dispute, an improved outlook for global growth supported relatively bullish investor sentiment. This nascent optimism has been brought to an abrupt end by the coronavirus pandemic. Its wide-ranging impact represents both a severe demand-side and a supply-side shock. Although the government has responded with sizeable fiscal and monetary policies on an unprecedented scale, the UK is nevertheless facing one of its deepest recessions in history, and earnings and dividends are expected to fall sharply this year, with the shape of a recovery uncertain. The direction of equity markets will likely continue to be driven by developments relating to the disease. The UK stock market, however, remains relatively attractively valued and has been out of favour for some time, exacerbated by Brexit uncertainty since June 2016. The chart on the front page shows that, on forward P/E multiple terms, UK equities moved to a discount to global equities after the EU referendum, and the disparity has widened considerably since to a near period low of c 17%. A return to pre-Brexit levels would suggest decent upside for UK equities.

DIVI was launched in April 2011 with the objective to generate an attractive level of dividends as well as capital growth over the long term, through investing mainly in UK equities across the market cap spectrum. Unconstrained by index considerations, this gives the managers, Gervais Williams and Martin Turner, a wide universe from which to find attractive companies. Their investment approach is bottom-up, looking for companies that are able to generate sustainable cash flows, which can underpin long-term dividend growth. Williams and Turner are smaller company specialists, and often find the most interesting investment opportunities in this segment of the UK equity market. Small caps can operate in sectors that are not represented by companies in the mainstream indices, thereby offering genuine diversification benefits. Furthermore, they can be overlooked by sell-side analysts, which can result in underappreciated valuations. Gearing is permitted up to 15% of the fund; however, historically it has been rarely used, reflecting the managers’ propensity to protect against downside risk. The managers have used derivatives, such as put options on UK large-cap indices, to cushion the portfolio against sharp falls in equity markets.

Williams believes the current coronavirus pandemic is causing major demand- and supply-side dislocations for the UK economy, with most companies negatively affected. The initial sell-off in UK equities was been broad and sharp, including companies with strong balance sheets. In his view, many companies have over-borrowed during this past decade of unprecedentedly low interest rates, and may suffer a permanent loss of capital or even go bust. Williams says DIVI has assiduously avoided companies with excessive leverage, and he expects its holdings to be able to continue their original trajectory of growth and dividend payments post the current period of dislocation. However, he is cautious that prospects for recovery from the current recession could remain muted for some time as governments, companies and consumers focus on deleveraging, and spending is constrained. In this environment, large companies may find it relatively harder to grow. Williams has also been cautious for some time that seemingly attractive dividend yields, which have helped underpin the performance of many large-cap companies for the past decade, were unsustainable. He observed that dividend cover has been falling over this period and, even prior to the current crisis, many high-yielding and widely held stocks had already cut dividends.

Williams believes the UK is relatively well positioned compared to many other major economies, with a flexible currency, and the ability to set its own policy. The depth of its capital markets is also a significant advantage, and he highlights that the UK is distinctive for its vibrant small- and micro-cap equity market. Smaller companies have underperformed large caps for some years, particularly since the Brexit vote in June 2016, yet the manager believes they can offer exposure to robust and growing businesses that represent genuine diversification from mainstream indices. In his view, good stock selection will become increasingly important in the current environment.

DIVI follows a bottom-up investment process to find companies that generate strong cash flow payback on their capital expenditure, which helps to underpin the ability to sustain growing dividend payments over a three- to five-year period. The managers are very experienced small-cap equity specialists, and over time have met many companies to help build their confidence over managements’ governance credibility and their ability to execute. Williams and Turner have an established framework for evaluating the attractiveness of a company:

Exhibit 2 shows the portfolio’s exposure by sector to end-April 2020. Financials account for over a third of DIVI’s holdings, and increased by 4.1pp over the past year. Consistent with the managers’ preference for smaller companies with niche strengths, most of the investments are in specialist financial services, and the trust has a relatively low weighting to the high-street banks. DIVI participated in the IPO of debt restructuring specialist FRP Advisory in February 2020. The managers favoured the counter-cyclical nature of its business, reflecting their cautious view on the high levels of indebtedness within UK corporates. The portfolio’s financials holdings have shown good resilience during the current weak markets. Among the better performers are the online trading companies CMC Markets and Plus500, which Williams identified should do well at times of rising stock market volatility. DIVI also has exposure to insurance companies that specialise in relatively defensive domestic market segments, such as Admiral and Direct Line.

Recent purchases include Russian gold and silver mining company Polymetal. Williams noted that the price of gold would normally appreciate in response to a pandemic; however, precious metals prices fell in tandem with the market – a surprise correlation that he believed represented a buying opportunity. Pharmaceutical company GlaxoSmithKline was also introduced into the portfolio, reflecting the managers’ confidence that the resilience of its underlying business should enable it to continue to pay dividends.

Significant gains have been made from the sale of a put option on the main UK large-cap index. The managers had purchased the put when they perceived market volatility to be unsustainably low, as an insurance policy to protect the portfolio in the event of a sharp fall in UK equities. A number of holdings have been sold in response to the pandemic, including transport companies easyJet and Go-Ahead, and entertainment company Rank. Healthcare-focused communications group Huntsworth was subject to an attractively valued takeover by an American private equity firm. These activities have contributed to relatively high levels of cash. As at end-April, DIVI held net cash of 8.7%, and following the sales of the put, this was as high as 14% in mid-March. This has allowed the managers to take advantage of market weakness to add selectively to existing holdings and make new purchases when opportune, without the need to sell at a time when share prices are broadly depressed. Many existing holdings have also been topped up; however, cash levels remain higher than usual as the managers take a cautious and patient approach to its reinvestment.

As shown in Exhibits 4 and 5, DIVI’s NAV total return has meaningfully outperformed the CBOE UK All Companies, MSCI UK High Dividend Yield and CBOE UK Small Companies indices across all the time periods shown. This is particularly noteworthy for the shorter-term periods of three and six months, when the equities sell-off in response to the coronavirus pandemic has been broad-based. DIVI’s outperformance has been significantly boosted by its put option, which has generated large gains. The portfolio’s holding of conservatively managed companies with strong balance sheets has also contributed towards its relative resilience. Since the trust’s inception in April 2011, DIVI has outperformed the CBOE UK All Companies Index by 63.7%.

At 19 May 2020, DIVI traded at an 8.1% discount to cum-income NAV, which is below the three-year average of 2.1%, but represents a sharp recovery from the 22.7% level in late March, its lowest point in history, as shown in Exhibit 7. DIVI has historically traded close to its NAV, an objective of the board. The board has the authority (renewed annually) to buy back shares if it considers it to be in the best interests of the shareholders, and also operates an annual redemption facility (see Capital structure and fees).

DIVI is a conventional investment trust; there are 378.3m ordinary shares in issue. The trust has an annual redemption facility that allows shareholders to tender their shares at NAV less costs at the end of May, and requests must be received by the end of April. For FY20, 20.2m requests have been received, representing 5.4% of issued share capital (FY19: 5.5m shares, representing 1.4%). The management fee payable to Premier Portfolio Managers has been reduced from August 2019, to 0.9% on the first £300m market capitalisation of the Trust, then 0.8% on any market capitalisation between £300 and £600m, reducing to 0.7% above £600m. Fees are charged to both the capital and income accounts, allocated at 75% and 25%, respectively. Gearing is permitted up to 15% of NAV, and the trust has a £25m loan facility with the Royal Bank of Scotland. This has not been drawn, and as at end-April 2020, DIVI had a net cash position of 8.7%.

DIVI’s primary objective is to provide shareholders with an attractive and growing level of income, as well as deliver capital growth over the long run. As shown in Exhibit 8, since the trust was established in 2011 it has grown its regular dividends to shareholders (paid in February, May, August and November), as revenues have grown. The trust has also built up a revenue reserve that is available to smooth future dividends to shareholders. Over recent months, as numerous UK quoted companies have reduced or cancelled dividends due to the pandemic, DIVI’s revenue has fallen back somewhat. Subsequently, the board has declared a maintained third interim dividend to shareholders, and stated that it is hoped that the trust’s revenue shortfall wil prove to be temporary, so the four dividends for the financial year to May 2020 may be at least similar to the previous year, through utilising some the trust’s revenue reserves from previous years.

Exhibit 9 shows the 12 largest funds by market capitalisation in the AIC UK Equity Income sector (which consists of 24 funds). DIVI is one of the smallest trusts within this peer group, ranking 10th. Its NAV total return ranks first over one year, fourth over three years, and second over five years. These returns have been generated without the use of gearing. DIVI has the highest ongoing charges among peers, which partly reflects its smaller size but also, in the managers’ view, the labour-intensive nature of running a multi-cap fund with considerable weighting in small- and micro-cap companies. The dividend yields shown are based on historic payments, and many UK companies have cut their dividends in response to the pandemic, which may result in lower payments for the current year. At present, DIVI’s yield ranks ninth, and the board has indicated its intention to utilise revenue reserves to help maintain this year’s dividend at last year’s level. The trust’s discount to cum-fair NAV ranks ninth.

DIVI’s board consist of six independent non-executive directors, chaired by Michael Wrobel, who has performed this role since the trust’s inception in April 2011. He has announced that he will retire at the October 2020 AGM, following nine years of service. The board has been proactive in succession planning in view of the tenure of the original directors, and has appointed three new directors over the past three years. Andrew Bell (appointed in January 2019) serves as the senior independent director. The other members of the board, and their dates of appointment, are Paul Craig (April 2011), Calum Thomson (December 2016), Caroline Kemsley-Pein (January 2019), and Michelle McGrade (October 2019).