Aiming for a diverse income from spread betting and mines

Many UK companies cut or cancelled their dividends last year and Diverse Income Trust (DIVI) was not immune from this. Its revenue over its half year to 30 November, of 1.77p per share, was 11.1 per cent down on the 1.99p per share it earned during the same period the year before. But the trust has maintained the first two dividends of its current financial year at the same level as the year before, and its board expects that the total dividend for the current financial year will at least match last year’s 3.7p.

Paying out this amount may involve drawing on the trust’s revenue reserve. This was worth £14.4m at the end of November and could roughly cover about a year’s worth of dividends at this level.

Gervais Williams, who runs the portfolio with Martin Turner, says it has been a mixed picture in terms of the trust's holdings’ payouts.

“Some portfolio holdings have already found that they were overly cautious in the March to May 2020 period, so have subsequently resumed dividend payments after only a short break,” he says. “Direct Line Insurance (DLG) and Admiral (ADM) car insurance companies, for example, have not only resumed their previous dividend policies, but also paid additional dividends during this period to make up for those passed in the period between March and May 2020. Media and entertainment technology solutions company Amino Technologies (AMO) has come back at a slightly lower level even though it’s probably going to grow at a much faster rate – they expect their sales to grow threefold over the next five years. And some companies actually grew their dividends. We have holdings in spread-betting companies such as CMC Markets (CMCX) which has thrived during the volatile stock market conditions and considerably increased the dividends paid to investors.”

The focus on companies "generating premium cash and cash growth in terms of dividends” also helped total returns last year. So, despite a fall of nearly 10 per cent for the FTSE All-Share index, Diverse Income Trust made net asset value (NAV) and share price total returns of 8 and 9 per cent, respectively, in 2020. Between March and November, for example, CMC Markets', AO World's (AO.) and 888's (888) share prices appreciated substantially as their businesses continued to thrive through the global recession. Between them, they enhanced the trust’s return during that period by over 4 per cent.

Williams and Turner favour stocks with attractive dividend growth and sustainable dividends. “So we’ve always gone for companies with strong balance sheets,” he explains. “And going into the downturn we tended to have fewer consumer stocks as we weren’t finding great dividend prospects among these – they were quite leveraged and sometimes the costs of their staff were going up faster than their revenues. That was very fortunate because when Covid-19 arrived we weren’t too badly affected.”

Exceptions to this include gaming, casino and bingo operator Rank (RNK) and Go-Ahead (GOG), which they sold.

“Rank is a very well run bingo operator, but as soon as Covid arrived people weren’t going to go to bingo or the casino, so it was a straight sell for that reason,” says Williams. “The main thing that makes us sell a stock is if we feel that the potential for income and income growth going forward is going to be much less attractive. We tend to look for companies that are generating an abnormal cash payback on their past or current investment, and a cash payback in the short to medium term. Unfortunately, we get things wrong sometimes: if the sales or margins turn down on a sustained basis, the outcome is much less cash generation. And less cash generation means that we are not going to get the dividends. But generally we didn’t need to sell many income shares at the time, although we did have some companies that cut their dividends.”

They also added new holdings that should help the trust’s income going forwards, such as more financial and mining stocks, which they say are on unusually low valuations. “Many of these stocks continue to generate sustained and growing dividends,” says Williams. “They provide access to growing distributions at a time when many others have cut their dividends.”

The trust's holdings in financials include spread-betting companies and insurers such as Phoenix (PHNX).

“There’s been opportunities to buy into these kinds of companies and, more recently, we’ve bought into companies like Just (JUST) which provides annuities," says Williams. "The valuations of some of these are remarkably overlooked. I think that’s partly because they’re UK, partly because they’re complicated financials and partly because people haven’t spent a lot of time reviewing them recently. There’s been terrific opportunities to make some active selections to add value.”

The trust has held gold mining stocks for a long time because of their individual merits and hedge benefits in more difficult market conditions. Recent additions to this area include Polymetal International (POLY).

“It’s about diversifying risk – having less correlated assets,” says Mr Williams. “The mining sector is a bit out of tune with others, and the gold mining companies are wonderful because the gold price sometimes goes up in a crisis. So they don’t just go through the crisis okay, they actually grow their dividends. The advantage of mining companies isn’t just that they are less correlated, or generate cash and dividend growth, but they are one of the few sectors that improves in terms of profits at times of inflation. If inflation is coming – and there’s a lot of chat about it – it’s lovely to have stocks that actually improve when quite a few other companies are struggling.”

Kenmare Resources (KMR), meanwhile, was added in 2018 before it started paying dividends in 2019.

“We don’t mind buying companies that are generating a disproportionate cash payback where they’re fairly early in the dividend cycle,” says Williams. “We think that it's going to make disproportionate profits and cash, and the dividend growth is going to be very substantial. It has produced some income in the past couple of years, and we think it is going to produce very substantial income going forward. Over 15 years, Kenmare has invested on the coast of Mozambique to bring a long-term illuminate sand project onstream. With the investment phase now largely complete, the company is moving into a position where it will generate a cash payback that is abnormally large compared with its market capitalisation."

Diverse Income Trust's managers have scaled back holdings relating to coal extraction and it doesn’t hold any pure-play coal mining companies, although it does have BHP (BHP) whose activities include coal. Williams and his team also take environmental, social and governance (ESG) factors into consideration when selecting stocks. Mining companies have raised concerns in areas such as pollution and working conditions, but the team has focused on engagement here.

Williams says: “We’ve been engaging with our companies to minimise risk in areas such as governance, health and safety, and employee engagement. Mining companies have been engaging with local communities in a more major way than many others. Some of the holdings which have the best sustainability reports at the moment are mining companies. We also need to work with them to reduce their carbon footprints. If we can engage with them, and provide capital for them to reduce their carbon footprint going forward, I think that’s a terrific way of investing our clients’ capital."

Aiming high

Diverse Income Trust had a third of its assets in Aim shares at the end of December, a market seen as higher risk and not immediately associated with income. But Williams argues such stocks can work well in a portfolio.

"A lot of these companies are market leaders in their own industries, but are smaller [than stocks associated with income such as] Royal Dutch Shell (RDSB)," he says. "So people assume that they are going to have small market positions. But they have very substantial market positions, often where they’ve been investing for many years, and are generating a cash payback which can give them a real advantage. So you can get not just income but income growth from them.”

He cites Strix (KETL) as an example, which makes about 40 per cent of kettle switches globally.

“This is a market that is very well established, although it is slightly less mature than you might think because Americans until recently didn’t have kettles. Although they’ve discovered kettles more recently only about 15 per cent of Americans have them. Prior to listing, Strix was a relatively mature supplier of kettle switches to the household appliance market. After de-gearing on listing in July 2017, it has been able to step up reinvestment in the business and penetrate new markets such as the US. And in March 2019, it acquired the Halosource assets, a business with 20 years of investment in two technically advanced water purification systems that are proven to kill near 100 per cent of water borne viruses and bacteria. Halosource has the potential to deliver a very substantial cash return after acquisition, although Strix only paid $1.3m (£930,000) for it because it was sold by a distressed seller.”

Strix expects to pay a dividend of 7.7p in respect of 2020, the same level as the year before.

Williams says that stock markets with a heritage of generating imminent cash flow and paying premium dividend yields such as the UK have tended to struggle to keep pace with higher beta stocks. “The UK is looking pretty cheap and, for the last four years, has been out of fashion because of Brexit,” he adds. “Going forward, a lot of companies – if they don’t see their share prices recover – may well see takeovers. That would drive the UK stock market up so the UK is quite well positioned to outperform other stock markets around the world."

And he argues that the recovery potential for the FTSE Aim All-Share index is even greater than for the FTSE All-Share index.

“Over the past few years some of the growth stocks have been the most popular,” he says. “People haven’t spent a lot of time looking at income shares, especially when they’re outside the largest stocks, so they’ve completely ignored some of the mid-sized [income generating] Aim companies. [As a result] these often stand on much lower valuations. The UK stands on a sub normal valuation relative to international comparatives, but many of the smaller quoted companies stand on particularly sub-normal valuations so there’s bigger catch-up potential.”

Gervais Williams CV

Manager of Diverse Income Trust since launch in 2011, when he joined Premier Miton where he is now head of equities and manages a number of funds.

Fund management career of over 30 years including 17 years at Gartmore where his positions included head of UK small companies.

Member of the Aim Advisory Council and board member of the Quoted Companies Alliance.

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