Gervais Williams: US tech could fall a long way

Diverse Income Trust manager Gervais Williams warns that some investors are exposed to too much stock-specific risk due to strong share price gains over the past two years for a few US technology companies, the so-called Magnificent Seven.

He makes the case for investors to re-examine the UK stock market, which has cheaper valuations. In particular, Williams is bullish on the prospects for UK smaller companies and names companies he finds attractive in terms of delivering growing income, including Greencoat UK Wind (LSE:UKW) investment trust.

Diverse Income Trust Ord (LSE:DIVI) is one of interactive investor’s Super 60 investment ideas, a selection of funds to help customers, as part of wider research, narrow down their options from a wide range of investment products.

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Kyle Caldwell, funds and investment education 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 Trust. Gervais, good to see you today.

Gervais Williams, manager of Diverse Income Trust: Thank you very much for inviting me in.

Kyle Caldwell: Gervais, I wanted to start off by asking about performance. On a three- and a five-year view, the trust has underperformed the average UK equity investment trust in terms of its share price total return. Could you explain why that's happened?

Gervais Williams: Yes. The nature of returns is that it's partly income, good and growing income. And, if you look back to five years ago, the start of Covid or just before Covid, what we saw in the UK market was dividend cuts. Shell (LSE:SHEL) is now paying less than it did five years ago. So, the UK has not grown its income very well. Interestingly enough, the portfolio's done perfectly well. The companies which succeeded, the income has come through. The trust itself has generated good and growing income over the last three to five years. So, generally, that's been absolutely fine.

What we have seen is valuations come under massive pressure. And what we've seen, particularly three years ago and subsequently, is many local investors, many wealth managers have taken capital out of the UK to participate in the terrific performance in the US. And it's not just that they put more money into a company which is doing well in the US, but taking money out of the UK has depressed their share prices.

The FTSE 100 companies have held up pretty well. These are generating surplus cash. They're able to buy back their shares. Their share price valuations have come under a bit of pressure relative to the US, but they've still generated a reasonable return.

Many of the smaller quoted companies, which are investing in their business, aren't in a position to buy back their shares. In many cases, even as they succeed, their share prices have been drifting. And those companies which have successfully exceeded expectations, their share price might have gone up, but nothing like as much.

So, if you look under the bonnet, yes, the fund has generated less return over the last three and five years than many of those which specialise in the very largest companies. But, if you look at the underlying health and the underlying opportunity in terms of how well they've done in the last five years, I would argue the Diverse Income Trust portfolio's done just as well as theirs, it just hasn't been shown in share prices as yet.

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Kyle Caldwell: However, in terms of the one-year return, the trust is ahead of the sector average by seven percentage points. Could you talk us through why and highlight some stock examples that have been key contributors to performance?

Gervais Williams: Yes. What's been interesting about the last 12 months is that small companies have stopped going down. The AIM market's still down over the last 12 months. Some of the mid-cap index is slightly up, but generally they’ve just stopped going down. So, all that's happened, really, is the portfolio hasn't changed very much. There are a couple of new holdings, a couple of holdings we’ve taken profits on, but the portfolio hasn't changed because there's less pressure and these share prices are driving that. Actually, the performance has come through.

What’s amazing is it’s not just kept up with the main market, it’s actually produced a better return than the main market, which says that even without small-caps having a period of performance catch-up, which they’re sure to do at some stage, it’s amazing.

So, coming back to it. Yes, take Galliford Try Holdings (LSE:GFRD), for example, a mainstream construction business. Three years ago, its market cap was below its net cash balance. It had more cash on the balance sheet making profits than it did in market cap. Strangely enough, over the last three years, particularly last year, it traded very well.

The share price is now around £400 million market cap, so that’s come through very happily. We’ve seen quite a few companies which have been coming through not just keeping up, but slightly outperforming. Yu Group (LSE:YU.), which is a utility business. Again, we’ve seen that starting to come through. We think there’s plenty left.

Some of the mainstream stocks have done OK, too. So, generally many mainstream companies have done pretty well. Some mid-sized companies probably dominated the returns, things like XPS Pensions Group (LSE:XPS), which went nowhere for several years. Big acquisition, did really well, and what’s been happening over the last three years, the share price has more than doubled.

So, coming back, yes, there’s some mid-sized companies coming through, a lot of the small companies haven’t really moved as much. But it’s just a few mid-size companies that have generated that performance. We think there’s lots more to come.

Kyle Caldwell: You mentioned that there's not been too many changes to the portfolio, but there have been some new names. Could you talk us through some of those most-recent purchases?

Gervais Williams: Yes. So, one example, take Greencoat UK Wind (LSE:UKW). This is a company which is obviously involved in wind turbines. The share price has very much plateaued over the last three years because people worried about the industry, but the company’s done perfectly well, and it’s generating plenty of income. The income is growing very happily. The valuation’s come all the way down. It’s a mainstream company, about £3 billion market cap. But you do get anomalies in some of these areas.

We also take profits, and we’ve had a couple of bids here and there. But, generally, all we’ve do needed to do is just top up our existing holdings. We’ve hardly needed to change the portfolio at all.

Kyle Caldwell: You mentioned Greencoat UK Wind. Is that the only renewable energy infrastructure trust that you own, or have you bought others?

Gervais Williams: That's right. We don't have many. To be honest, we're not against them, but they don't generate the surplus cash we look for as a whole. So, yes, that one is doing so. Most of the others, they're fine, but they don't have as much upside. So, we're much more involved often in industrial businesses, manufacturing businesses, financial businesses.

The areas which have done extremely well have been things like some of the mining companies. As you know, the gold price has been very strong. Pan African Resources (LSE:PAF), for example, which is one of the leading gold mines in South Africa, has generated a lot more cash now because, of course, the gold its trading out of the ground is now worth 60% more or whatever than a year and a half ago. So, from that point of view, it's generated lots of cash.

So, some of the mining companies have come through, even some of the energy companies have started producing a return. Energy prices have come down, but are starting to go back up again. So, it's been the wide range of companies which have come right rather than one or two specifics.

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Kyle Caldwell: We're recording this interview towards the start of a new year. Can you talk us through the outlook for UK dividends in 2025? And are there certain sectors that you view as being more dependable than others?

Gervais Williams: The main thing about the future is we think the range of outcomes is very wide. We've just got Trump coming into office and we don't know the policies he's going to apply, but more importantly, we don't know the unexpected side effects, the unexpected setbacks that might come along with that. And, of course, we don't know how other countries are going to react. If he does impose all sorts of tariffs, then they may have obviously their own tariffs to put against it. So, we think the range of outcomes is extremely wide.

On the other hand, inflation has been up there, interest rates have been up there. There is an expectation of interest rate cuts. Again, we don't know quite how quickly that's going to come through. Not just because inflation may not come down as fast as expected, but governments themselves are looking to spend quite a large amount of money, not just in the US but also in the UK and other global economies.

So, we think there's a really unsettled year coming up. We think global growth will be hard to persist at these levels. We may see a slowdown in the US. Clearly it's already quite weak in Europe. China's not growing much. The UK is flat. So, coming back to it, we think it's going to be an unsettled period.

The big question we don't know is, how much profit margin is going to come under pressure. At the moment, global profit margins around the world have been sensational over the last 30 years. We're near record levels and we can kind of work out what's going to happen. They may level off for a while. They may go even a tiny bit higher. But over the next three or five years, we think profit margins are going to come under extreme pressure. So, how do companies hold on to profit when some of their competitors are cutting prices?

And that's where service levels come in. When we select companies for the portfolio, we look for companies which aren't just good but outstanding in service levels. If they are outstanding, hopefully they hold on to their customers. Hopefully they don't have margin pressure, they can hold on to profitability and cash generation at a time when others are losing out. That means that, one, they get a competitive advantage, but, two, they are able to invest in that business when others aren't and you get a disproportionate advantage going forward.

We think the world's going to get very unsettled. We think good and growing income is going to get quite difficult. But those companies, which don't just succeed but outperform, will generate disproportionate returns.

Specifically, we think it's a period when picking the winners from the losers is going to get important, i.e. active management. We think indexation has been a great way to make money. That's all about participating in markets, but if markets are more unsettled, they don't go up much. And if you find stocks which can grow up even when the market's not going up, then it's that added value, which we think is going to become important. We think the Diverse Income Trust is superbly positioned for that.

Kyle Caldwell: I'd just like to ask you a further question on the point that you just made regarding index funds and exchange-traded funds (ETFs). We've seen for a number of years now a lot of investors go into global index funds or global ETF and US index funds and ETFs, and they've done very well out of it. How would you convince an investor to back the UK and to back a UK active fund manager like yourself?

Gervais Williams: Well, we know it's been great and let's be honest, we don't know what's going to happen this year. Maybe things will be even better than they were last year. The Magnificent Seven rose 70%, or something like it, last year. Extraordinary. Are they going to do another 70% this year? I don't know. Possible? I don't think it's likely, but it's possible, right.

But the nightmare is that you know at some stage that the excitement's going to get past and it'll peak out just like in 2022. And it won't just come down, it could come down a long way. So, a lot of clients are holding a lot of stock-specific risk. Individual companies are becoming a more significant part of their portfolio. And if you do get disappointments in stock specifics, you can lose a lot of money really fast.

You've also got a sector bias towards US technology, the mega-caps, and so if you find that, for whatever reason, something happens to them, you've got correlation risk, you've got stock-specific risk, and it's a good idea to not just put it all on one type of holding.

And so coming back, the great advantage about the UK market isn't just that it's overlooked, and it's cheap, but more importantly, it produces most of its return via income, cash income. So, if you want to take profits on some of your US technology stocks, great. But you need to buy well and sell well. It's very transactionally led.

Good and growing income, you sit back on your sofa, like you, and basically you get your income every three months and then you get another one, another one. So, you just get this income coming in all the time. And if markets are unsettled and you want to buy something more with your income, perhaps the share prices are lower, you can add.

So, coming back to it, we think the return is going to be important, characteristics, it's not just about transactionally capital gain, good and growing income, we think, is going to become horribly important. Not just to private investors, but to global investors. And as that starts to come through, valuations start to come through, then you get the momentum in the UK.

The UK outperformed the US stock market dramatically between 1965 and 1985. We've all forgotten it can happen. We think that pattern is going to happen again. So, we think it's a good time to take a little bit of risk off those very successful holdings and bring it back to the UK, so that as the pattern changes, you're ready for the next step.

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Kyle Caldwell: Are you a buyer of the UK? Do you have skin in the game in Diverse Income Trust?

Gervais Williams: You bet I do. I've been buying more, not just in Diverse Trust, all my clients’ holdings. I don't invest directly in the companies themselves, I just buy the funds. It's a great advantage because then I know what's in it, of course. But more importantly, I'm very upbeat about the potential for the UK to outperform, not just versus other global markets, but even the US market.

Specifically, I think we're coming from an overlooked and undervalued position, so I think there's a bit more catch up. I think small companies specifically. I think [there's] too much bigness in most clients' portfolios. I think small-caps can run around the feet of the majors when there's an uncertainty. I think the small-cap sector, particularly where they make acquisitions from distressed insolvent companies.

We saw HSBC make an acquisition of SVB UK, the Silicon Valley Bank. They paid a pound for that. What did it add to them? £5 billion. Now they were £160 billion already. Fine. Every £5 billion is worth having. But if you're a small cap, say a £1 billion market cap, you make an acquisition which adds £500 million, then that's great news. If you're a £200 million company, you make an acquisition which adds an uplift of £200 million over two or three years? That's even better.

So, the advantage is going to be in smallness, the advantage is going to be the UK, the advantage is good and growing income. I'm more upbeat now than I've been for 30 years.

Kyle Caldwell: Gervais, thank you for your time today.

Gervais Williams: Thank you very much, really enjoyed it.

Kyle Caldwell: So that's it for our latest Insider Interview. Hope you enjoyed it. You can let us know what you think, you can comment. And for more videos in the series, do hit that subscribe button. And hopefully, I'll see you again next time.