Diverse Income Trust cuts exposure to UK consumers

Victims of the consumer cull include broadcaster ITV (ITV) and pub chain Greene King (GNK), while the trust exited betting firm 32Red as a result of a takeover by Kindred Group (0RDS).

Diverse Income Trust's remaining consumer companies are held for stock-specific reasons rather than high conviction in this sector. For example, top 10 holding IG Design Group (IGR) is classified as a consumer discretionary business, but operates in a niche sector with little competition. The firm manufactures wrapping paper and has been expanding overseas, making it less exposed to struggling UK consumers. The managers took some profits on this, but it still accounted for 1.3 per cent of assets at the end of January. 

They have also reduced exposure where they think company profit margins could come under pressure. "We have been more cautious on companies operating in areas where there is multiple competition," says Mr Williams. "Just a single change by a competitor does not undermine the profitability of other companies in a given sector."

Instead, they are focusing on niche sub-sectors where holdings are likely to be less affected by competitive action such as price wars.

Mr Williams thinks that substantial profit margin growth for companies has come to an end, and that the economic system that has allowed profit margins to double since 1985 will now change. This economic system is also to blame for a lack of productivity growth and wage inflation, and that is showing few signs of changing – hence his bearish stance on the UK consumer.

"Our sector weightings have changed a lot over the past 12 to 18 months," adds Mr Williams. "We have become very cautious on the consumer and invested in other areas."

The changes mean that financials are now the trust's largest sector exposure and accounted for 22 per cent of assets at the end of 2017. These include Park (PKG), a gift voucher and prepaid gift card business, and A&J Mucklow (MKLW), a real estate investment trust (Reit) focused on industrial and commercial property in the Midlands. They accounted for 1.1 per cent and 1.4 per cent of assets respectively at the end of February. 

Diverse Income Trust's net asset value (NAV) rose 18 per cent and its share price rose 17 per cent in 2017, ahead of the FTSE Small Cap (ex Investment Trust) index's increase of 15.6 per cent. Performance so far in 2018 has been hit by choppier markets. But the trust's managers expected this, so increased the trust's holding in a FTSE 100 put option – a derivative that is an insurance policy against market falls. This accounted for 1.8 per cent of the trust's assets at the end of January.

The put option gives the trust the right to sell the FTSE 100 at 6500 even if the index level falls below this level. This would limit losses if markets took a downward turn. One-third of the value of the trust's NAV was covered by put options, but its managers have increased this to 40 per cent and extended the maturity from March 2019 to September 2019.

Mr Williams says that if the FTSE 100 fell to 4500 the put option would pay out over £40m – close to 13 per cent of the trust's assets, allowing him to reinvest the cash when share prices are substantially lower.

"It does cost money," Mr Williams says. "But recently the cost of put options has been falling, despite Brexit and the changes in government. So just before Christmas we extended the put options for [Diverse Income Trust]."

Put options have an initial cost and their value falls over time. The one the trust holds will become worthless if the FTSE 100 index doesn't fall below 6500 before September 2019 when the put option matures. However, Mr Williams says the risk of fallout from Brexit negotiations and the UK's leave date in March 2019 is worth being protected from.

"This is aimed at keeping some of the trust in cash so we can buy more stocks at stressed valuations, if the worst-case scenario comes and the market has an extreme wobble [over Brexit], or the oil price goes through the roof because there is a bust-up in the Middle East," explains Mr Williams.

Diverse Income Trust (DIVI)

Source: Morningstar as at 20.03.2018

Share price performance

Source: FE Analytics at at 20.03.2018

Top 10 holdings as at  31.01.2018 (%)

Source: Miton Group

Sector breakdown (%)

Source: Miton Group as at 29.12.2018