Small-cap rebound can deliver income and growth at this discounted trust

Small and mid-sized UK companies performed worse than their large-cap peers when interest rates rose, but a reversal in their fortunes is under way as central banks begin cutting rates.

One trust caught up in the turbulence has been Diverse Income Trust Ord (LSE:DIVI), a Super 60-rated strategy that aims to deliver an attractive dividend yield, as well as capital and dividend growth, by looking at UK firms of all sizes.

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In its latest annual results, to the end of May 2024, returns picked up in the second half of the year to produce a 12-month return in line with the benchmark. But outperformance could make a comeback, argues ii fund data analyst Alex Watts. He looks at how the investment trust has performed, how it is managed, and analyses the outlook.

The numbers in detail (for financial year to 31 May 2024)

NAV (Net Asset Value) Return: +15.4%
Share Price Return: +12.7%
Benchmark 1 Return (Deutsche Numis All-Share): +15.6%
Benchmark 2 Return (Deutsche Numis SC + AIM EX ICs): +12.5%
Dividend: 4.25p(vs 4.05p prior year)
Premium/Discount: -8.6%(vs -6.2% prior year)
Gearing: Nil

Performance

The reported period marks a pick-up in performance for Diverse Income Trust following a poor prior year of absolute and relative returns to end of May 2023.

The trust’s net asset value (NAV) return for the year of 15.4% is almost in line with a broad UK market index (Deutsche Numis All-Share) return of 15.6%, and exceeds a small-cap (Deutsche Numis SC + AIM ex IC) index return of 12.5%.

A slight widening of the discount throughout the year made for a 12-month share price return of 12.7%. Commensurate with the story for the wider UK market, and small-caps particularly, following a fairly flat first six months, the beginnings of a shift in sentiment in favour of UK equities saw the trust’s positive performance loaded in the second half of the year, with a NAV return of near 17% in the second half.

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The strongest contributions came from a selection of Diverse Income Trust’s financials holdings, namely XPS Pensions, CMC Markets, TP ICAP. Financials are a key overweight for the trust.

Other outperformance came from gold miner Pan African Resource, construction business Galliford Try, and new addition Yu Group, a utility supplier.

There were relatively few substantial detractors to speak of, while a put against the FTSE 100 – a protective strategy that has paid off in prior periods – detracted a small amount.

Outlook

The team are confident in the upside potential of investing in UK small-caps given the meagre valuations across the UK market, and especially at the smaller end of the spectrum. This is seen as a “one-off” devaluation, rather than being indicative of a more systemic issue with UK Plc.

It is noted that the UK market has (in distant history) produced multi-decade outperformance versus US equities – a scenario that management thinks could repeat itself.

Discount

The trust traded throughout the period at an average discount of -7.1% (versus -5% in the prior year). Having begun the reported year at a near -6% discount, the trust finished the year at a discount of -8.6%, which detracted from the ultimate shareholder return. The trust currently trades at a similar level.

Dividend

The dividend for the reported year saw growth of near 5%, to a distribution of 4.25p per share (subject to AGM approval). This payout was more than covered by revenue return, which has grown by more than 7% since the prior year.

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Portfolio

The year saw holdings in Forterra, Kitwave, Jet2, Mondi and Vistry sold on the basis of perceived stronger returns elsewhere.

Capital was recycled into the aforementioned new addition, Yu Group (which quickly became a top contributor to returns), as well as into energy names including Shell (LSE:SHEL), Ithaca Energy Ordinary Share (LSE:ITH) and Hunting (LSE:HTG). \

There was a good amount of M&A within the portfolio at premiums to market valuations. Nonetheless, management were disappointed to see these businesses taken out of the market at what they believed to be less than fair value.

As is typical for the strategy, there is diversified exposure across a range of business, both large and small. But there’s a longstanding bias across the 120-stock portfolio to the very small end of the spectrum, with AIM-listed businesses accounting for just under 30%, and FTSE small-cap another 20% of the portfolio, although some familiar large-caps provide exposure and income from the top end of the market.

ii View

While Diverse Income’s bottom-up approach focuses on the income-paying attributes of companies, the hefty bias to small-cap greatly distinguishes the trust from peers that, more typically, derive income from across large-caps.

It is a factor that can also make for periods of underperformance versus an all-of-market index. Such was the case in 2022 when large-caps drastically outperformed small-caps, as redemptions of funds investing in smaller companies played a role in suppressing valuations.

This latest set of results marks an encouraging return to form for Diverse Income Trust, which rebounded in the latter half of the reported period. While overall returns were dampened slightly by a persistent discount to NAV, some hope may be derived from the fact that such a discount (near -9%) is a relative rarity for the trust, which spent a not insignificant portion of the last decade trading at a small premium.

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The manager’s report touts the imperative role of the dividend in total returns for equity income strategies, and we shouldn’t overlook the strong revenue growth seen within the portfolio in the year, and the resultant increase in the dividend payout.

The current yield of near 4.5% is testament to the team’s approach to finding and growing income by looking beyond the large-cap names that top the FTSE 100 index.

The defensive focus on well capitalised, cash-generative dividend payers, in tandem with a conservative decision not to leverage, means we wouldn’t necessarily expect this trust to greatly outperform small-cap strategies in a rising market.

However, in the context of the strong reversal of performance for smaller quoted UK businesses that began in the fourth quarter of 2023, the trust has clearly achieved capital growth, while also fulfilling its objective of growing its income payouts to investors, supported by revenue increases.

Performance will need to continue to strengthen in order for the trust to restore its three-year track record versus an all-share benchmark and equity income peers over three years, given the weakness of small-caps in 2022 and in the first half of 2023.

However, the trust’s long-term record since Williams and Turner’s tenures began in 2011 boasts annualised outperformance of 2% above both all-share and small-cap benchmarks, while maintaining an upward trend of dividend payouts. 

This differentiated approach leverages the wealth of expertise that Williams and Turner have across AIM and small-cap to tap into the capital return potential of smaller companies, while also providing an attractive level of income.