Diverse Income Trust (The) — Manager is the most bullish in the last 30 years

Considering the macroeconomic environment, Williams says that inflation has been less of a problem than was generally expected, as energy prices have peaked, logistics operations are now more fluid with some container prices down by 80%, and due to inventory destocking, which is deflationary, as a result of over-ordering in 2022. He comments that US spending has peaked; there is no bond issuance as the federal debt ceiling has been reached but US stocks had a strong start in 2023 due to abundant liquidity.

The manager says that the performance of UK stocks has been disappointing due to widespread selling of open-ended investment companies (OEICs) since the 2016 Brexit vote, with 2022 being one of heaviest years, and redemptions continuing in 2023. There has been demand for shares in the largest UK companies due to their representation in investment vehicles favoured by international investors such as income and energy exchange-traded funds. Small-cap and AIM stocks have not recovered with Williams stating that the valuation differential between AIM stocks and the rest of the UK market is the widest in his career. He also comments that he has not seen such a wide spread before between the price-to-book ratio of the UK market (1.5x) and DIVI’s portfolio (0.8x), while the UK market is trading around a third the level of US stocks. The manager thinks that the UK market does not need a return of international investors for UK stocks to rally, suggesting that an end to OEIC selling would be sufficient. He sees considerably more upside potential in AIM stocks compared with the shares of large-cap UK companies. When questioned, Williams opines that the potentially recessionary combination of higher inflationary pressures and interest rate hikes that exceed consensus expectations could be a headwind for the performance of UK stocks.

Commenting on his observations from company meetings, the manager says that businesses tend to be well capitalised, are investing in a range of good opportunities and are generally passing on higher input costs. Williams says that he has become more confident about the outlook for energy prices, as companies have been holding back investment in fossil fuels and have had to pay windfall taxes. He considers that there could be a global energy shortage, evidenced by higher gas prices even before the war in Ukraine and declining US stockpiles. The manager comments that new energy discoveries are only 30% of global consumption, adding that alternative energy projects are high cost, and supply can be intermittent particularly wind and solar energy.

At end-January 2023, DIVI’s top 10 holdings made up 20.0% of the fund, which was a higher concentration compared with 17.4% a year earlier; five positions were common to both periods.

Exhibit 2 clearly shows DIVI’s multi-cap portfolio with just c 20% in large-cap stocks and a further c 15% held in mid-cap companies. The largest changes in the 12 months to end-January 2023 are a higher weighting to small caps (+4.7pp) and a lower mid-cap exposure (-1.6pp).

At end-January 2023, DIVI had 127 holdings spread across all 11 market sectors. While DIVI’s sector exposure is diverse, it has a notably high weighting in financials, which make up around a third of the fund. This compares with a less than 25% weighting for the broad UK market. The financials sector also provides an even higher percentage of the trust’s income at 36.6% (reported in its end-November 2022 interim results).

New additions to DIVI’s portfolio in recent months include:

The trust’s managers are generally happy with DIVI’s portfolio companies but there have been a small number of complete disposals. Consultancy firm K3 Capital Group was acquired at a modest 17% premium to its pre-bid share price, but the 350p per share takeout price was more than 250% higher than the April 2017 listing price. In January 2023, Direct Line Insurance Group issued a weak trading statement as claims increased due to a prolonged period of cold weather and car prices continued to rise, which negatively affected the company’s underwriting results. There will be no final dividend in respect of 2022. Energy company SSE had announced plans to reset its dividend in 2024.

DIVI has a large-cap index put option (c 0.3% of the portfolio) that currently extends to December 2023. 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. During the COVID-19 induced March 2020 stock market weakness, the managers took profits on DIVI’s put option and used the proceeds to increase the trust’s UK microcap exposure at depressed prices. This boosted DIVI’s returns during the market weakness and in the subsequent market recovery.

Williams explains that AIM income stocks have been under pressure since Q321, as investors have favoured large-cap dividend payers, which has had a negative effect on DIVI’s absolute and relative performance.

Considering the trust’s results over the last six months, the manager says that the largest positive contributors include: K3 Capital Group (received a takeover bid, which was highlighted earlier in this report); Hostelworld Group (according to Williams, this business is just starting to receive recognition and should generate significant amounts of cash); and Sainsbury’s (low market expectations, Argos is performing well and the company as a whole is generating strong levels of cash flow). Over the same period, the largest detractors to DIVI’s performance were Independent Oil & Gas (operational difficulties, position was sold); i3 Energy (lack of appetite for this small-cap stock despite the company’s c 6.2% yield and rising dividend payments); and the trust’s large-cap put option.

While DIVI’s underperformance versus the broad UK market since Q321 has affected its longer-term track record, it remains considerably ahead of the Numis All Share Index over the last decade. The trust has fared better versus small-cap stocks, with its NAV having outperformed the Numis Smaller Companies ex-Investment Companies Index over the last three, five and 10 years.

DIVI is the 11th largest fund in the 20-strong AIC UK Equity Income sector, a peer group with a large range of market caps. The trust is differentiated from the other funds in the sector by having a multi-cap approach, investing in a wide range of companies from those that are relatively immature through to major well-established multinational businesses. DIVI’s income is generated from c 130 holdings, so if an individual company cuts its dividend, it should not have a significant impact on DIVI’s revenue stream, whereas the peers, apart from Law Debenture Corporation, have a shorter list of stocks, so their income is more concentrated.

The trust’s NAV total returns are above average over the last decade ranking fourth, while trailing the mean returns over the other periods shown. The last year has been characterised by a shift in investor appetite from growth to value stocks and a wide divergence between the performance of large- and smaller-cap UK equities, which has been detrimental to the performance of DIVI’s multi-cap portfolio.

On 1 March 2023, the trust stood at a 5.2% discount versus the 4.1% sector average. DIVI has one of the highest ongoing charges, but its multi-cap approach provides lower-than-average volatility and a low correlation to equity markets. In keeping with its peers no performance fee is payable. The trust is currently the only fund in the peer group that has no gearing. Its dividend yield ranks 11th and is modestly lower than the sector average.