Manager Gervais Williams has a very good track record to support his contrarian views. Additionally, investing in this trust might add much needed stock diversity to your portfolio.
Diverse Income (LON:DIVI) is one of the most successful new trust launches of recent years. The £140 million launched in April 2011 and which sits in the AIC Income & Growth category, has had a profitable second year with a total return of over 40%, which makes it easily top quartile.
Investment Trust Analyst met with the manger of this interesting trust.
Background
Of course a year is a very short time to measure the success of an investment by. To understand more about the fund and its strategy it’s useful to start by looking at its lead manager Gervais Williams.
Williams has been a fund manager for 17 years, and was formerly the head of smaller company investing at Gartmore from the early 1990’s till he left the company 2010, a year before it collapsed in to the arms of Henderson.
According to financial data company Trustnet, over a 13 year period, on average his funds have delivered a total return (share/unit price growth plus dividends paid) of +9.8% per year. He has also consistently beaten the performance of his peer group over 1, 3, 5, 7, and 10 years delivering 241% as against 195.8% over the 10 year period.
So, what about those contrarian views I mentioned earlier………..
About the Trust
Diverse Income has one simple aim – to produce good and growing income over time.
The trust has no benchmark which means it can and does invest across every area and size of the market, from small companies to large ones such as BT Group, one of its largest investments.
Gervais Williams worked on a similar basis when he managed funds at Gartmore (now Henderson) such as Garmore Irish and Garmore Growth funds.
He looks to minimise stock specific risk by having a large number of holdings, around 100 or so, and spread across many different sectors.
The trust has the lowest volatility of all the income funds in its sector.
Stock selection
With dividends being such an important feature of this trust (more on that later) it is the most important characteristic in their stock selection process.
They look for companies that are capable of paying increasingly higher dividends. Note, they don’t need to be high dividends at the point at which they invest but there does need to be the ability to increase them over time.
They describe themselves as being transfixed about balance sheets. As Gervais said “We really don’t know if Spain or Italy will go out of the Euro. We don’t want to be changing horses half way through, we want to have companies that can sustain their dividends. If they can do this then their share prices will be less affected and they can take advantage of any of these incredible one off events that might occur”.
Thesis of Gervais Williams: 7 Year small company bull market beckons
When I met with Gervais Williams recently I found out where he is positioned now and the next few years. I’ve kind of given it away in the section heading above so no need to read any further…………just kidding, there’s a wee bit more to it than that.
The really good news, if you subscribe to his standpoint, is it is not too late to invest with him as his thesis is still very much being played out and has several more years to run.
For much of the last few years, we have been in a risk on/risk off investment environment. During the financial crisis investors were either prepared to invest in ‘risk assets’, which is anything other than Government bonds/cash, or they weren’t willing to invest in ‘risk assets’. If you called this right, it didn’t really matter what risk assets you were vested in because they all went up, almost in unison.
This has broken down over the past year or 18 months as it was always bound to. The question is what next? It’s a question that has excited Gervais Williams and his small team at Miton, and they think they’ve identified some of the investment theme’s that will grow and develop over these next few years.
As we’re now around 18 months or so in to what has been a period of rising stock markets it’s clear that the risk on/risk off trend has come to an end and with it the inexorable rise of high beta (stocks that are more volatile or risky than the market).
Another change we’ve witnessed is a huge reduction in the volume of shares traded, but Gervais thinks we’re just going back to normal and that we’ve forget how thin trading was in the 1990’s. He said “It used to be that maybe there was only 5 billion shares traded a day. During the credit boom with all the hedge fund activity it rose to typically 40 billion shares traded a day, eight times as much. Now what we’ve seen in a rising market is volumes coming down and a lot of people have been saying well that can’t be right, but it is right. It’s not quite so apparent because as asset prices have doubled as the market has gone up, it means that the value of shares traded hasn’t come down by as much as the volume of shares traded has”.
Gervais argues the reason for the fall is down to the banks no longer funding a lot of the activity of the high frequency trading by hedge funds. He added “now this is what is occurring in a rising market, in a market that’s not rising my view is liquidity is going to become more restricted again and of course the regulator is very concerned about liquidity”.
The BRIC Countries
it’s not the credit boom that was ordinary; it’s the periods outside the credit boom that are ordinary
Probably the most sensitive area for investors at the moment is the BRIC countries. The purpose of investing in the BRICS was to give investors access to growth outwith the Western world, an opportunity to diversify returns and to get better returns when Western markets aren’t doing well. But BRIC countries have sat out from the recent bull run, declining a couple of percentage points. They’ve been grappling with issues like high inflation and restraints on their currencies which is hitting them quite hard.
So the question is, are these trends temporary or permanent? Gervais’ view is they are permanent, and by that he means decades long.
Why does he think that? He referenced the chart below, debt to GDP levels for the US. It shows how things peaked and after the 1920’s credit boom when the US had a long period of stability and debt was under control. Then from 1985 onwards they saw a rise in the availability of debt which resulted in increased borrowing.
“GDP growth has been good in the US but despite that debt has grown faster and this has been during a period where asset prices have been risen up. The average price of a UK house in 1985 was £33,000, in the first quarter of this year it was £238,000, recent reports were it hit £250,000. So effectively during the last 25 years it’s been advantageous to be speculative and it’s encouraged fund managers to engage in speculative activity. Prudence has generally been an area where you’ve lost relative performance and you’ve generally not performed well for that reason”.
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Gervais thinks that pattern change has been pretty much baked in, and that a number of fund managers whose entire careers have been during the credit boom period might have difficulty adjusting as they’ve known nothing else. He explained “the reason why I bring this up is it’s not the credit boom that was ordinary; it’s the periods outside the credit boom that are ordinary. We’re moving from having been in a period that was extraordinary back to a period where the ordinary investment rules start to reassert themselves”.
Hunt for income
corporate profit margins which have doubled from their historic 4% of GDP to 8% will narrow and as a result dividends will have to be cut
We already know that one of the patterns that has already been asserting itself is the hunt for income. Interest rates are 0.5% so if you can get something that is paying 3-4% then that is really valuable. Particularly if it’s a growing yield.
Over the last 18 months the mega-income paying stocks with a market cap of £10 billion plus such as your BAT, Shell, Glaxo, haven’t really performed and Gervais believes this is because everyone has enough exposure to them already, they can top up but they don’t need to buy a lot more.
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Gervais believes that investors hunt for income has been driving them down the valuation scale in the market and that is what the above chart illustrates.
First they went for the dividend paying mega-caps, then on to large and mid-cap stocks and the chart above shows they’ve gone up by 40-45%. The important investment point he makes is that this hasn’t yet reached the sub £100 million market cap stock, but Miton believe this is beginning to happen and that it will filter down to there more as investors continue to look for yield.
He added “there’s lots of companies below £100 million with good yields, solid cash flow, low debts, strong balance sheets capable of paying increasing dividend yield on P/E’s of 8-9 at the bottom of the market”.
Can investors rely on these income paying stocks to keep delivering the goods? “Probably not, clearly 2008 was a seminal example of what happens when stock markets collapse. Some companies slashed their dividends. We think there is a danger that the dividends of many income paying shares will come under pressure. Many utility companies in particular have only been able to afford their increasing dividends by ratcheting up debt. This leaves them vulnerable to any change in attitudes for the availability of debt from banks.
In this austerity world in which we operate, corporate profit margins which have doubled from their historic 4% of GDP to 8% will narrow and as a result dividends will have to be cut”.
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The chart above goes back to 1900 and assumes dividends are reinvested. What it shows is £1 invested in equities in 1900, that paid the market average in dividends would be worth £23,335 if you reinvested the income (not including the costs) today, which is pretty incredible.
This is the power of compounding and it is widely known and recognised and which we talk about a lot here at WhichInvestmentTrust.com.
What’s interesting about this particular chart is that it shows the success of various strategies, and this makes for surprising reading. If you had decided to invest in companies that had the best management teams, forecasts, prospects then of course these companies would typically have high expectations and a low yield (remember the yield of a share is simply the share price divided by the dividend. Share prices move up and down daily whereas dividends are set yearly/half yearly, and so the yield goes down as the share price increases).
The trouble with high expectations is over time it is very hard to grow faster than these high expectations. Perversely, if you get involved with stocks that are boring, with unexciting management or prospects who perhaps as a result have high yields because the share price is lowly rated; well, occasionally these companies surprise the market by beating expectations and you get a revision upwards. And so if you look at this chart those low expectations, high yield stocks produced 100,000 times your money. This includes dividend cuts, recessions and depressions. This is a trend that has been with us for over 100 years, it’s just gone out of visibility during the credit boom.
Gervais Williams, Manager Diverse Income Trust
He added “we think that investors are going to increasingly look for income as a proxy for measuring value; and if they can get 4% a year, increasing and compounding to 4.5, then 5% then it won’t matter to them so much if the market is up or down that year, because they can measure their success by the power of compounding their investment”.
How long does he expect this scenario to play out? “This is a five to ten year view. People have become so used to viewing capital growth as the way to riches that it will take some time for this new thinking or old thinking to get wedded in. But, the great thing about equity markets is the early movers get disproportionate advantage. If we’re right about this then more capital will follow us in and there will be a one off revaluation upwards”.
Small Caps
if you’re already big, organically doubling your size is a big ask in normal times but it’s a doubly big ask when the economy is not growing
“More controversially, perhaps, what we also expect to happen over the next few years is that small caps will outperform something rotten over the next 7 years, something rotten!
They’ve already, quite inconveniently for some fund managers outperformed last year by quite a large degree, and they’re outperforming this year. It’s asking questions of investors in a way that they don’t expect to be asked questions. The bottom end of the market is meant to be very cyclical. When the economy is going down it is supposed to be more closely aligned to this and go down also. But although it does include speculative companies on AIM like oil and gas, there are quite a lot of businesses doing very nicely.
The great advantage of being small is you have a greater chance of organically doubling your size. The disadvantage of being big is that if you’re already big, organically doubling your size is a big ask in normal times but it’s a doubly big ask when the economy is not growing”.
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If Gervais is right about the direction of interest in smaller companies then one thing that would support the success of his thesis is the lack of representation on the share registrars of small caps by the large institutions.
He explained “anyone who’s wanted to sell small companies over the last 25 years has had a number of grand excuses; they’re not liquid enough, higher volatility, not exposed to globalisation, they underperform, not geared enough, can’t trade them on a daily basis. Every institution has had every excuse that they wanted to come out of them and they have. This is a one of the only sectors of the market that is radically under owned by institutions”.
“If you look at this chart (above) the All-share index made something like 90 times your money and the red line, which represents small companies up to £100 million market cap, made 500 times your money. And the really small companies, under £50 million market cap, which is the blue line made 1000 times your money. So the smaller the better and institutions are radically underweight tidily companies”.
“The other thing is that the bottom end of the market is the most under researched. So, for fund managers willing to do the work there are very few analysts looking at these companies. You can add a lot of value (as a fund manager) if you spot these undervalued assets”.
At Miton Gervais works with a team of four that go around and meet companies. Often Miton are the only institution on the register.
Because of their size and the illiquidity of their shares building stakes can take some time. Gervais gave the example of James Cropper, a manufacturer of paper products where it took them around two years to build up a meaningful holding.
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Merger with Miton Income Opportunities
Miton Income Opportunities was originally called Gartmore Fledgling, and then it became Henderson Fledgling. It changed name again when Miton took over the mandate early this year. The intention was always to merge it with Diverse Income and boards announced on July 2nd their intention to proceed with this.
Once complete the trust will be valued at something like £210-220 million. At this level it is likely to
WhichInvestmentTrust.com View
Investment Trust Analyst likes managers with a strong conviction and a clear sense of where they want to go. Diverse Income Trust manager Gervais Williams has both of these attributes and a past record of outperforming his peers.
No manager gets everything right but with appropriate levels of risk management in place, a 2:1 ratio should be all that is required to drive good returns to investors.
We like that by investing in Diverse Income investors are exposed to a very different set of underlying holdings than other trusts in the sector.
If Williams is right and corporate profits come down to their historic average, he is also likely to be right in identifying dividends as being a key driver to future investment returns.
We think Diverse Income Trust should be a core holding in many investors portfolios and it joins our buy list of recommended funds.
Diverse Income Trust Investment Trust Metrics
Share Price
67 pence
Dividend Yield
3.13%
5 year dividend growth p.a. = N/A
Total/Market Cap (Million)
£137m / £139m
Gearing
0%
Managed by Gervais Williams & Martin Turner since 28/04/2011
AIC Sector/Date Founded
UK Growth & Income / 28/04/2011
On-going charge & how much of the charge is the managers fee
1.97% / 1%
Managers direct holding: Has a large personal holding.
Discount to NAV
+1.7%
12 Month Average Discount to NAV
+3%
Financial year end: 31/05/2014
Total Return 1, 3, 5 & 10 years
+41%
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-
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UK Growth & Income Sector Total Return 1, 3, 5 & 10 years
+32%
+71.5%
+120%
+217%
FTSE All-Share Index Benchmark Total Return 1, 3, 5 & 10 years
+23%
+44%
+56%
+146%
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