Strong FTSE and weak small-caps stall Diverse Income

The last financial year was a frustrating one for diversified UK equity income trust as poorly-performing smaller company shares and insurance policy to protect the portfolio from market falls pushed it into a small loss.

The last financial year was a frustrating one for Diverse Income (DIVI ) as poorly-performing smaller company shares and an insurance policy designed to protect the trust from UK market falls pushed the closed-end fund into a small loss.

Having notched up a gain in the previous 12 months of over 33% under Premier Miton fund managers Gervais Williams and Martin Turner, the year to 31 May saw the £346m investment company fall 3.4%, against a 4.7% gain in the UK stock market.

Diverse Income, an equity income trust investing across the entire UK stock market with three quarters of its assets in companies outside the FTSE 100, suffered as big blue-chips did well as investors sought safety in larger companies.

Put out

The relative resilience of the FTSE 100 meant a ‘put’ option strategy Williams and Turner successfully used to protect the portfolio in the coronavirus crash two years ago backfired. The 0.6% invested in the derivatives contract that allows the managers to make money if the FTSE crashes was their largest loss-making position in the year as it lost value as the index posted a positive return.

This was the opposite of 2020, when the duo sold a similar put at a profit and reinvested the gains in depressed smaller company share prices that subsequently bounced back. 

Undeterred, the pair last month bought a new FTSE option as insurance against a market drop next year. ‘The option has a lower strike price of 5,700 (compared to 6,200) which should moderate its potential cost if the FTSE 100 continues to be resilient,’ they said. The FTSE currently trades at around 7,541.

Williams (pictured) said the fund’s multi-cap bias had been ‘something of an impediment’ this year, as the largest companies with the majority of their business generated overseas receiving an earnings boost from weak sterling.

CMC Markets (CMCX) is a case in point. The spread betting and contracts-for-difference trading platform is currently the third largest holding in the fund making up 2.4% of the portfolio having been trimmed by Williams.

After a pull-back in the shares this year it became the second biggest drag on performance after the put option, although Williams still believes in ‘the potential for it to deliver even greater returns in future’.

Energy was ‘easily the strongest’ performing sector for DIVI over the year, adding 4% to the trust’s returns in aggregate, with top holding i3Energy adding over half this total. Utilities also performed strongly, with power generation group Drax (DRX) and energy supplier  (NG) contributing 1% to returns between them.

Cashflow crisis

While there were some bright spots over the year, Williams admitted he is ‘anxious’ about a future of lower profit margins as inflation pressures weigh on companies.

‘With inflation it appears that many businesses could come under margin pressure, as demand moderates, and companies seek to hang on to customers, even if this involves cutting prices,’ he said.

‘Generally, businesses delivering poor customer service are often the most vulnerable in these circumstances. Conversely, companies delivering not just good, but outstanding levels of customer services can sometimes retain their customers even when others are offering similar services at lower prices.’

Williams warned that the lack of quantitative easing and interest rate rises rather than cuts that are defining this economic slowdown means some companies may be ‘faced with a server corporate cashflow challenge that may persist for some time’.

Income boost

There was better news on income the company receives from its 129 stocks. Revenue per share rose from 3.73p to 4.01p, in line with its  pre-pandemic level, putting the trust on track for a 4% uplift in dividends to 3.9p per share and leaving a little surplus to add to reserves that can be used in the future when company payouts are weaker.

Despite a 5% rally in the past month, DIVI shares have fallen 13% this year, matching the decline in UK smaller companies and trailing the 1% gain in the FTSE All Share.

Over 10 years they have done much better, generating a 161% total return for shareholders, beating the FTSE All-Share’s 96%, but over five years have trailed the benchmark’s 23% return with a 16% gain.

The shares yield 4% and stand at a 7% discount below net asset value (NAV). 

 

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