Gervais Williams: UK market to outperform for 10 or 20 years

Gervais Williams, manager of Diverse Income Trust (LSE:DIVI), tells interactive investor’s Collectives Editor Kyle Caldwell, why he is so bullish about the UK stock market’s prospects over the next two decades, and in particular why he is excited about the valuation opportunities he's seeing among UK smaller companies.

He also explains why his optimism hasn't been knocked by the prospect of a recession in 2024, discusses opportunities among AIM-listed stocks, and talks about his hopes that a new British ISA will be introduced. 

Diverse Income Trust  is a member of interactive investor’s Super 60 list of fund ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Gervais Williams, manager of the Diverse Income investment trust. Gervais, thanks for coming in today.

Williams, manager of Diverse Income investment trust. Gervais, thanks for coming in today.

Gervais Williams, manager of Diverse Income investment trust: It's a pleasure to be here.

Kyle Caldwell: The Diverse Income Trust invests across the UK market but has a particular preference for UK smaller companies. Given that UK smaller companies are out of favour, but historically smaller companies have outperformed large companies, is that a source of comfort in times such as these?

Gervais Williams: Yes. We need to be worried if we all move into recession, [a] UK recession, potentially a global recession if interest rates remain higher for longer and then, clearly, it's difficult for all businesses, big and small. So, it's not a walk in the park for anyone. But what's interesting about small companies is often they're more immature, which means that if they lose market share during a recession in one part of the market, they can sometimes make up for extra market share in others.

Specifically, you often find during recessions, that some of your competitors go out of business, which means that various parts of the market are vacated and you can expand into those areas more easily. And just occasionally there are companies which become insolvent. These are viable businesses, over-indebted, and they become insolvent, and you can buy those from the receiver often for a nominal sum and put more capital, get those staff back to work and generate a disproportionate amount of cash.

So, coming back to those features, all those tend to favour smallness over bigness. And so, you do find those small companies are affected. Some do go bust, but some don't just survive, they thrive. What's interesting about the smaller company sector is the last time it had a period of outperformance was from March 2020 onwards, right in the middle of the pandemic, right in the middle of the global recession, right in the middle of the period when we didn't know that there was going to be a vaccine. It was a time when that sort of flexibility and the agility of small-caps came through.

So, we're quite excited, really, about the potential [of] the smaller side of the Diverse Income Trust to generate premium returns, as well as the mainstream FTSE 100 companies, which have already been outperforming versus internationals over the last three years, to sustain outperformance further going forwards given their cash flow surplus.

Kyle Caldwell: And your optimism is despite the fact that the UK economy might enter recession in 2024?

Gervais Williams: Absolutely. If you go back to the 1960s and 1970s again, this is a period when the UK economy didn't grow very well. We had the three-day week. We had all sorts of problems with the rise in the oil prices and quite a lot of companies going bust at that stage. So, the UK economy itself wasn't a stand-out candidate versus the global economy, but the UK stock market, the mainstream stock market, outperformed not just most international stocks, including the US, the S&P index by an absolute mile, and the best-performing parts of the best-performing market in that time was the smaller part of the UK market. So, that’s tremendously exciting.

The last 30 years when I see my clients, I say hopefully the strategy has the advantages that it can generate a premium return versus the UK, and the UK is going nowhere for the last 30 years, so people think it’s a bit dull. Everything’s outperformed the UK. In fact, right now we’re in a position where if we’re right about the future, not only does the UK performance continue, but this part of the market has a catch-up. The small-cap has appeared to catch up and outperforms the overall return of the funds and better than most international strategies, as well as most UK strategies.

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Kyle Caldwell: And central to that period of catch-up, as you’ve just mentioned, is the fact that the valuations are so low today compared to history?

Gervais Williams: Yes. I think valuations alone on the UK market as well, when you've underperformed for 30 years, you know there's not much expectation in there. So, if you take a price to book, which is a measure of value, you know how many assets you've got working for you relative to your share price. And if you take the FTSE 100, it's about 1.6 times, 1.7 times. If you take the S&P 500, it's something like 4 times, 4.2 times. So, you can see the valuation is almost half now. Nearly everyone says, well, that's all right. Well, we haven't got all those technology stocks, all those growth stocks. Yes, but what we have is lots of companies, which are generating surplus cash.

A lot of our companies in the UK market are capital intensive. That means that as the cost of capital goes up, the competition dies away. So, many of these companies aren't just well-positioned to survive with their cash-flow surpluses, they're able to take advantage of the weakness of others to improve their market positions.

So, the UK market is cheap in its own right when you move down the market-cap range [and] the smaller companies in our view are even cheaper price to book ratios, even lower. And it’s that factor, which means that when we do get this period of outperformance of small caps, I don’t think it’s just a one- or two-year thing.

My own view is that the UK market continues to outperform for 10 or 20 years from here and the best-performing part of one of the best-performing stock markets going forward will be the smaller companies and they hopefully will also - not every year - have a long-term trend of outperformance versus the FTSE 100.

Kyle Caldwell: And in terms of the mid- and small-cap part of the market, how much longer do you think investors need to wait for that outperformance? I mean, if we're in a scenario of interest rates being higher for longer, will that continue to be a headwind?

Gervais Williams: Yes, I mean, it could be a headwind. But what's interesting is that it can change just like that. So, we don't want another pandemic, but that was the catalyst which led to small-caps outperforming. You wouldn't have known a month before that it was coming, but it came and small-caps did really well afterwards. So, we can't always be sure that we can tell the catalyst. Clearly, it'd be nice if we can encourage that catalyst going forward.

Premier Miton have been engaging with regulators and particularly the government to say that when it comes to ISAs, why should they be investing in international companies like NVIDIA Corp (NASDAQ:NVDA)? Why not keep more of it home? Why don't you ringfence a part of the UK ISA allocation each year to go into UK quoted companies?

Now if the government did announce that, I think that would lead to less selling, local selling, in the UK market. I think that would help the performance of the UK mainstream stock market. But I think we'd also see a particularly big catch-up at the bottom end of the market with small companies, so it may be quite close. We don't know. What is quite exciting is that we can see there is that period to come. And whether it's soon or perhaps early next year, we can afford to wait around.

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Kyle Caldwell: Around a third of the portfolio is in AIM-listed stocks. Have some companies in that index been unfairly sold off given the risk sentiment towards AIM and smaller companies is very low?

Gervais Williams: The key feature has been overhanging sellers, not many buyers, and so even companies which succeed have seen their share prices drifting down, typically. Companies which have disappointed, which may mean they're still going to succeed longer term, they may not need any extra capital, but if they've disappointed, their share prices fall even faster.  So, you've seen certain companies come all the way down.

Clearly, even when you succeed, it's quite hard for your share prices to go up. Yu Group (LSE:YU.) has bucked the trend, most others haven't. So, coming back to it, yes, there are some companies which were overlooked. I think the area which is most overlooked is the kind of slightly uncomfortable sectors. So, coming back to some of the financials, small financials are particularly overlooked, I would argue.

Small oil companies, energy, carbon-based energy companies. Again, I think, those which they may be addressing climate change longer term, but out of fashion at the moment, and mining companies, again, you know, FTSE 100 companies in this area are standing on a price-to-earnings ratio (p/e) of six times. So, clearly small companies are standing on PEs even lower than that.

Kyle Caldwell:Investment trusts have the ability to gear, borrow to invest. Given that you are seeing plenty of opportunities in the UK market, have you been increasing gearing levels?

Gervais Williams: No, interestingly, the trust has the ability to borrow, and over its entire 13-year history since we first set it up, it hasn't borrowed at all. And it's not because we don't think there's any advantage to borrowing, but the trust itself can make plenty of money without borrowing. And that's a good start because of the added value.

Second, you really don't want to be borrowed if things get caught out. If you were excited by the election in 2019 when Brexit, which had been a sort of gridlock in Parliament, is now going to be resolved, you could have cleared up the fund in the early part of 2020 and then been completely caught out by the pandemic when asset markets came down and you may have had to actually sell some of your holdings because of gearing at the bottom, locking in that underperformance. We're very keen to avoid that.

So, we tend to have no gearing and then after a market setback, if we think the coast is clear, if we think the risk/reward ratio is attractive, gear up after the event. So, the last time we've really geared our investment trust was back when I was at Gartmore [in] 2009, not 2008, but 2009. When markets bottomed [at] that stage you could see all that shock and awe of quantitative easing at the time. Interest rates had been cut from 5.75% to 0.5%.

This was an extraordinary period and then, being ungeared, we were then able to put gearing right at the bottom and make extra returns for clients. So that's when we use gearing. It's very flexible. It's very opportunistic. Let's not rush our fences. Let's wait for them to come to us.

Kyle Caldwell: I also wanted to ask you about a trend that's been taking place for a couple of decades now, which is that companies are increasingly staying private for longer. What are your thoughts on that trend? And, as an investor who likes to look at the small-cap part of the market, does that make your job harder?

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Gervais Williams: Yes. I think there's been very many fewer issues, IPOs, there have been a lot more takeovers. So, the number of listed companies has been reducing. That's been a feature of the UK market. It's been a feature of the US market and other markets, which have been doing well. So, coming back to it, I think the cost of finance, the cost of capital has been relative expensive relative to the cost of debt. And so, you find that many companies have chosen to have more debt, have less capital and therefore risk capital. And as a result of that, we find that many companies are skewed towards the unquoted.

I think going forward, with the cost of debt being higher, with potentially inflation being more persistent, with the risk of geopolitical events becoming more risky going forward, and perhaps the risk and volatility in things like the oil price and food prices, we think that having more risk capital, having less debt, is the secret of the future.

We think quoted companies will vastly outperform private companies going forward, in part because they are more resilient, they don't go bust so fast. But more importantly, as they're able to take advantage of the weakness of others, when those which are indebted may be constrained.

So, coming back to it, yes, it isn't helpful having companies staying private for longer, but we still have in the UK market a vibrant universe of small and micro-cap companies. If you take the investment companies below or quoted companies below £150 million market cap, in number terms, they exceed all the quoted companies above £150 million market cap. There's just bags of opportunity. We're not short of opportunity.

Kyle Caldwell: And finally, Gervais, do you have skin in the game?

Gervais Williams: Absolutely. I think it's important that all fund managers back their own funds. I don't invest in anything else other than our own funds. And, of course, the parent company.

Kyle Caldwell: Thanks for coming in today.

Gervais Williams: Thank you very much indeed.

Kyle Caldwell: That's it for the latest episode of our Insider Interview. You can check out the rest of the series on our YouTube channel. Please let us know what you think. You can comment, like and please do hit that subscribe button as well. And hopefully, I'll see you again next time.