Gervais Williams and Martin Turner
Diverse Income Trust Managers
For information purposes only. The views and opinions expressed here are those of the authors at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Resilience under pressure
During periods of equity market turmoil, it can be common for the most resilient returns to come from equity income shares. In part this is because the return that comes from accruing dividend income is unimpeded by equity market weakness. In addition, as share prices decline, dividend yields rise. This means already generous dividend yields become even more generous as markets weaken, partly counterbalancing the weakness of share prices.
The strength of the FTSE 100 Index
Given that the FTSE 100 Index is dominated by equity income shares, it is not surprising that it was amongst the best performing global indices during the market setback seen in 2022. What is more notable is that the FTSE 100 Index has remained one of the best performing global equity indices over the two most recent quarters.
Even more remarkably, this outperformance has occurred at a time when there have been near-record levels of UK OEIC redemptions. The implication is that there were other significant buyers increasing their FTSE 100 Index holdings that more than offset the local selling.
In our view, international investors may have been increasing their weightings in the UK stock market involuntarily. Global equity income funds tend to have large weightings in the UK because so many of the FTSE 100 Index shares pay generous income streams. We are hopeful that this may mark the very early stage of a new equity market trend, as investors increase their exposure to cash compounding strategies, in order to offset or diversify away from the large positions in capital gain strategies they may have built up.
The recent performance of UK smaller companies
In contrast to this positive trend, the share prices of AIM-listed smaller companies have been notably weak over the last couple of years. Like the FTSE 100 Index shares, these have seen ongoing near-record OEIC redemptions. But unlike the FTSE 100 Index shares, for UK smaller companies this has not been offset by new buying from overseas. As a result, the FTSE AIM All-Share Index has underperformed the FTSE 100 Index over the last two years. Such differentials in returns over a relatively short period is quite exceptional.
3-year performance of the FTSE 100 Index and the FTSE AIM market
Source: Morningstar data from 30.04.2020 to 30.04.2023. Past performance is not a reliable indicator of future returns.
How has the Diverse Income Trust fared against this background?
The trust’s return over the last two years has reflected the resilience of its holdings within the FTSE 100 Index, tempered by the considerable share price weakness of many of its holdings listed on the Alternative Investment Market (AIM). However, as the overall portfolio weighting to FTSE 100 Index shares is outweighed by a much larger weighting in shares outside the FTSE 100 Index, its return has lagged others in the peer group as they tend to have most of their portfolios invested in FTSE 100 Index shares.
In addition, the outperformance of the largest so-called “megacaps” in the context of the FTSE 100 Index overall has further depressed the Trust’s returns, given that its individual portfolio weightings tend to be modest.
Lessons of history
When inflationary pressures were building in the early 1970s there was a similar period of megacap outperformance amongst a group of shares known as the ‘nifty fifty’. This outperformance was however followed by a long period when the S&P 500 Index failed to reach a new high. Looking forward, we do not expect markets to be benign. The combination of reshoring, the restriction of immigration by nationalist politicians and the driving up of prices by the cost of capital and increasing debt levels will all tend to boost inflationary pressures and curb the ability of companies to supply inexpensively. It seems likely that the record profit margins in the US are set to decline in future years, as they did in the 1970s.
If corporate debt becomes more costly and supplied on increasingly tighter terms, thereby constraining global growth, this is liable to limit the number of companies that can sustain good and growing dividends in future.
Equity income portfolios that restrict their investment universe to a sub-set of the equity market, namely the very largest quoted companies, could be at a major disadvantage. Conversely, a cash compounding strategy that can invest in shares regardless of market capitalisation – such as that adopted by the Diverse Income Trust – might prove to have a substantial advantage. Investing across the full investment universe via a longer list of portfolio holdings should enable us to add value for investors in the future, as we have since issue.
The US budget ceiling standoff appears worrisome. There is a risk of a technical default on US debt commitments due to political posturing, potentially for just a day or two. Whilst we anticipate that the market will take a one-off development like this in its stride, we are nevertheless concerned that politicians may feel less urgency to agree budget ceilings in future.
Once the budget ceiling is agreed, the US will need to catch up on its bond issuance program. Doing so may drain asset markets of liquidity and initiate a period of bond weakness. Furthermore, as government bonds are considered low risk, additional issuance at lower and lower valuations can quickly ‘crowd out’ others such as corporates, precipitating a credit crunch. According to recent surveys, investors may already have the highest absolute bond weighting since 2009.
Reasons for optimism?
Against these downside risks, we envisage UK stock market outperformance accelerating. This has the potential to catch out local investors who have been cutting their UK weightings. If local OEIC selling was to cease, the outperformance of the FTSE 100 Index might accelerate yet further, and importantly some investors might ‘waterfall’ capital down the market capitalisation bands, and in so doing trigger a major period recovery by UK smaller companies.
In such an environment, companies generating surplus cash may find themselves even better placed than currently. We envisage a period of the strong getting stronger, as the weak risk insolvency. Equity income shares could outperform in this scenario with a growing availability of insolvent debt-free acquisitions to be made at knock-down valuations potentially enhancing the growth of the acquirers.
The combination of such low valuations for UK-quoted multi cap equity income shares and modest institutional allocations not only means the Diverse Income Trust has the potential to outperform the mainstream indices in the UK, as it has done since issue, but also to outperform international markets, as the cash compounding nature of UK stock market itself outperforms. Therefore, despite the trust’s recent underperformance, we remain upbeat about its prospects.
Diverse Income Trust performance since launch
Source: Morningstar data from 28.04.2011 to 30.04.2023. Past performance is not a reliable indicator of future returns.