The Diverse Income Trust — Manager anticipates a small-cap super cycle

Williams and Turner are very upbeat about DIVI’s prospects given the potential to generate good returns in different market conditions and believe that the outlook is even brighter in an unsettled economic and geopolitical environment. They are especially bullish about the trust’s small-cap stocks given their inexpensive valuations. In a recent interview Williams said, ‘I am more optimistic about the sector than I have been for 30 years; I think we are entering a super cycle of small-cap outperformance.’

Williams and Turner aim to generate a robust and growing income stream by investing in a broader range of UK-listed companies than the trust’s peers in the AIC UK Equity Income sector. They invest across the market-cap spectrum from larger mature firms to AIM-listed younger businesses, all of which are expected to generate excess cash that can fund meaningful and growing dividends.

DIVI’s less-diversified peers are reliant on fewer companies to generate their income, which is a riskier approach, while the trust’s multi-cap strategy provides a broader investible universe, which also reduces DIVI’s income risk. Companies that may not currently pay a dividend, but are likely to be able to do so as they exit a capex period, are also considered. Holdings are sold if their valuations are no longer attractive, with the proceeds reinvested into less expensive companies; this process provides a yield pickup, supporting the trust’s strong and rising dividend stream.

The benefits of an income focus in different market environments – despite the strong performance of growth strategies in recent years, this should be put into a broader context. Over the last three decades the globalisation trend has been pervasive, but throughout history there have been different macroeconomic backdrops; the managers believe that an income focus offers the prospect of good returns regardless of equity market conditions. They consider that during periods of economic uncertainty there is risk in focusing on capital appreciation, particularly on businesses that are dependent on raising additional capital. Companies with strong balance sheets can take advantage during economic malaise by acquiring their struggling competitors at advantageous valuations either in the market or debt free from a receiver.

Low interest rates have led to outsized equity returns – the globalisation theme has kept inflation in check and enabled a low interest rate environment. This resulted in outsized equity returns versus history as asset prices revalued and has encouraged narrower stock ownership with market winners attracting ever greater investor interest. Hence, there has been increased demand for larger-cap passive funds rather than actively managed smaller-cap strategies. Persistent selling of small-cap stocks, which are generally less liquid, has led to multiple compression and amplified the divergence between the performance of large- and small-cap equity returns.

The small-cap effect – while larger-cap companies may have been favoured in recent years, over the long term, small-cap businesses have generated superior total returns for shareholders. The managers explain that this is known as the ‘small-cap effect’, where the returns of quoted companies are inversely related to their market caps; hence, DIVI’s multi-cap approach, which aims to generate attractive returns whatever the market environment. UK stocks have performed relatively poorly over a multi-year period versus overseas markets, which in part have been supported by the strong performance of large-cap technology shares; however, this has not always been the case. According to the managers, during periods when the UK outpaced international markets, it was led by the performance of small-cap stocks.

Outlook for UK market in 2024 – higher interest rates bring risks to economic growth and if there is a recession this year, it should favour companies with excess cash. The managers say that economic weakness can disproportionately affect larger companies with strong market positions as it can be difficult for them to offset weaker demand with rapid expansion into other areas. In contrast, small-cap companies can be more agile in shifting their business emphasis. Also, in an unsettled interest rate and geopolitical environment there is typically inelastic supply in capital-intensive industries due to escalating build costs and higher required rates of return; if demand remains steady it can lead to very high margins for these corporates. The UK market has a large percentage of capital-intensive businesses so could be relatively well positioned in this type of environment. Also, within the UK, there are a relatively large number of quoted small-cap businesses, which tend to outperform during global economic weakness. Between 1965 and 1985, when there were persistent inflationary pressures and recessions, UK stocks fared far better than those listed in the United States and UK small-cap was one of the best performing global markets.

Exhibit 1 shows DIVI’s upside/downside cumulative capture over the last 10 years versus the Deutsche Numis Smaller Companies excluding Investment Companies Index. Its defensive portfolio qualities are shown by its upside capture of 66% and a downside capture of 61%. This low volatility, coupled with the trust’s outperformance since inception, implies that DIVI offers investors an attractive mix of high alpha and a below-average beta.

DIVI’s multi-cap exposure is shown in Exhibit 2. At the end of December 2023, large and mid-cap stocks made up just 40.2% of the portfolio. The reduced AIM exposure (-8.3pp) is likely due to the poor performance of these stocks rather than a conscious desire by the managers to reduce DIVI’s exposure to this market, which they expect to be a source of future large-cap winners.

At the end of December 2023, DIVI’s top 10 holdings made up 21.5% of the fund, which was a modestly higher concentration than 20.2% a year before; two positions were common to both periods. Over the year, the total number of holdings declined from 127 to 122.

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. In Exhibit 4 we show how DIVI’s sector exposure differs from that of the broad UK market. At the end of November 2023, the notable differences were below market weights in healthcare (-10.2pp) and consumer staples (-8.6pp) with a continued overweight position in financial stocks (+9.2pp).

Looking at Exhibits 5 and 6 below, it is interesting to note that DIVI receives a disproportionate amount of income from its industrial holdings (+7.1pp) and that the financial sector generates less income (-3.6pp) compared with its sector weighting. However, over the last five years, the financial sector been the largest contributor to DIVI’s income, particularly the large-cap names including M&G, Intermediate Capital Group, Legal & General Group, Admiral Group and Aviva. The best performing stock over this period was XPS Pensions Group despite it being a small-cap company.

While DIVI’s results in recent years have been disappointing during a period of small-cap underperformance, one should not forget the trust’s long-term record. Data from the company show that since DIVI’s launch in April 2011 until end-H124 (30 November), its NAV and share price total returns of +171.7% and +144.0% respectively compared with the Deutsche Numis All-Share Index’s +92.5% and the peer group’s +147.4% total returns.

The managers highlight two periods in recent years when poor sentiment has negatively affected DIVI’s returns. The first was from September 2018 to December 2019 due to concerns about political gridlock during Brexit negotiations. Secondly, sentiment towards UK small-cap stocks has been weak since April 2021, meaning good results have not been fully rewarded, while the shares of companies failing to meet expectations have been punished.

In H124, DIVI’s NAV and share price total returns of -1.3% and -2.2% respectively outpaced the Deutsche Numis Small Cap plus AIM (excluding investment companies) Index’s -3.7% total return but were behind the Deutsche Numis All-Share Index’s +1.6% total return.

Three positive contributors to the trust’s performance were: DWF Group (received a takeover bid, which the managers believe was too low given the company’s future prospects); XPS Pensions Group (sold its National Pensions Trust subsidiary to SEI Investments for a meaningful sum but will continue to earn administration fees from the combined company, which is now the market leader); and Galliford Try Holdings (announced another acquisition and raised revenue guidance).

The largest detractors to the trust’s performance were: I3 Energy (lower commodity prices); CMC Markets (increased capex and lower profitability); and Vanquis (reduced lending activity). All three companies remain in the portfolio as the managers have positive outlooks for these companies.

DIVI’s annual dividend has increased each year since the fund was launched in 2011. It should be noted that to allow shareholders to vote on the dividend, a final dividend of 0.50p per share was paid in FY15 in addition to four interim dividends, resulting in five payments for that year. Since then, there have three interim and a final dividend paid in respect of each financial year.

As shown in Exhibit 10, in normal market conditions, DIVI has a fully covered dividend. The most recent exceptions were during COVID when the FY20 annual payment was 0.9x covered and there was a small drawdown from reserves in FY21.

In H124, DIVI’s revenue return per share was 2.38p, which was 6.7% higher year-on-year. At the end of H124, the trust’s revenue reserve was c £16.9m, which is equivalent to around 1.3x the annual dividend payment. So far, in respect of FY24, two interim dividends of 1.00p per share have been declared, which are 5.3% higher year-on-year. The board expects to at least maintain the total FY24 dividend at 4.05p per share.