Gervais Williams and Martin Turner
Managers of the Diverse Income Trust plc
For information purposes only. Any views and opinions expressed here are those of the author 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
Investing involves risk. The value of an investment can go down as well as up which means that you could get back less than you originally invested when you come to sell your investment. The value of your investment might not keep up with any rise in the cost of living.
Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.
What we see happening in 2023
Looking ahead in 2023, it is likely that the UK is going to enter a recession. However, in terms of the UK equity market, it is also likely that this recession was ‘priced-in’ to a considerable degree during 2022. Company share prices (equities) have come down a long way in value, but if we have a recession, it is likely there will be further downgrades to company profit forecasts.
This has been one of the most widely expected recessions ever, but some companies will get caught out in terms of either expected profits or market positioning. As active managers, we are conscious that there is scope for some disappointment from the companies available for us to invest in, but the great advantage about listed companies is that they have typically more robust balance sheets to work with.
As quoted companies, they can acquire assets from their less well financed private peers which are financially distressed or have become insolvent. The acquisition of insolvent assets can help ensure that historic investment may still generate an attractive future return and may also secure tenure of employment for the employees of the businesses being acquired.
K3 Capital Group is an example of a company which announced a series of acquisitions in mid-2020 that its management described as transformational for earnings, and which have led to the company not just succeeding but securing far greater cash generation and growth in profits than it might otherwise have done:
K3 Capital share price (rebased to 100 when stock was first purchased in this Trust)
Source: Bloomberg data as at 30.12.2022
De-globalisation and navigating new headwinds
The world is in de-globalisation mode, and this has important implications for investment going forward. During globalisation, we saw the gradual replacement of expensive Western labour with cheaper Chinese labour. This resulted in lower inflation over the past 20 years. The reversal of this process – deglobalisation – results in higher inflation.
Whilst “reshoring” may make sense from a security of supply point of view, labour costs, regulation and current high energy costs mean it is also likely lead to cost increases for companies. Reshoring is the process of returning the production and manufacturing of goods back to the company’s original country. That is not to say it will be necessarily damaging to the economies that bring production back onshore, as the accompanying domestic investment and job creation will kick in to increase demand in the long term.
However, whether companies are fully able to pass on to their customers the additional costs associated with greater domestic production remains to be seen and will be important for their profit margins. In 2023 these may also come under pressure as we see consumers being more price sensitive. Despite these threats, there are likely to be corners of the stock market which will continue to thrive. There are no easy wins, but companies that operate in little niches where they have market dominance are more likely to be able to hold onto their margins.
The case for UK companies is building
The UK stock market is better positioned than many other markets in our view. Large UK companies, such as banks and energy companies, typically pay a stream of dividend payments to investors.
Stock markets such as the UK generate a major part of their return via the compounding of dividends, which can be a particular advantage when share price growth is more limited. Compounding of dividends is when you use your dividends to buy more shares, and then use the dividends from these new shares to buy even more shares, the dividends will compound and build in value over time.
Rising inflation may also mean that a wide range of asset classes increasingly move in sequence, rather than in different directions; this can make it ever-more important for investors to focus on diversification away from purely growth-focused investment strategies, towards those that generate returns via dividends and the compounding effect of these over time.
Based on this shift in focus for investors, we would expect the current selling of UK equities (company shares) to stop and be replaced with steady purchases. Such a move may improve the direction of the UK equity market and help raise its valuation relative to other equity markets. As an important side effect, increased interest in the UK market could also lead to renewed interest in small, quoted companies.
As a result, we think that a portfolio with a multi-cap approach such as the Diverse Income Trust is well-positioned looking into 2023 which is very exciting for us as managers. A multi-cap approach is when a fund manager invests in stocks of companies with varying market valuations (market-cap). So, with a multi cap approach you will find investments in large-cap, small-cap, and mid-cap companies.
How might the trust’s investments stand up to a recession?
As managers we are focused on investing in companies which we believe are resilient. That means that we need to find companies which have strong balance sheets, so that if there is a slowdown, they are not caught out. Their share prices may fall, but they are still able to fund their current dividends and keep investing for the future.
Our decision-making process considers the level of debt or gearing a company has. Within the Diverse Income Trust portfolio, we are cautious about investing in companies with substantial debt. Given the nature of economic cycles, there will be an economic recovery at some point, but our base assumption is that the consumer may not be as buoyant as in past recoveries and it could be that an extended cost of living crisis continues.
While the prevailing economic climate is not easy during and after a recession, what we are looking for is companies that occupy a defendable niche. Warren Buffet described the process of identifying such companies:
“What we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle.”
Similarly, within the Diverse Income Trust we are investing in companies with a clear market position and delivering outstanding levels of service. Outstanding customer service, as we have described previously, is a long-term competitive differentiator which helps companies to hold on to profit margin in a way that those delivering only average standards of customer service may not. Our investment philosophy has developed to include service levels as one of the criteria for selecting companies and we hope that this will serve us well through what may be a troubled economic period.
Building income momentum into 2023
There are just under 130 holdings in the Diverse Income Trust portfolio. Each one is relatively small in terms of the contribution towards income. But because of that, even when the level of income from a particular holding disappoints, it means that the underlying momentum of the trust’s income continues. Maintaining a good and growing level of dividend income is the cornerstone of what we are looking to achieve for investors.
In 2023 we will be looking to companies like Mears Group to continue building this growth in income. Mears is a business which looks after property for many of the UK’s housing associations. The group also helps international asylum seekers, by managing many of the hotels where these groups are housed. The underlying business is profitable, with outstanding service levels, and in our view, is well placed for the future. It is a small company with good prospects of cash generation going forward.
Mears Group Dividends
Source: Bloomberg data as at 30.12.2022. 2022, 2023 and 2024 dividend numbers are based on consensus analyst forecasts.
Investing within the closed ended harbour
Returning to the potentially tough market conditions we may see in 2023, one of the key advantages of managing investment trusts is that they are investment vehicles focused on the long-term and designed for long-term investors. Their closed end structure means they are not subject to the inflows and outflows of investors’ money when the direction of stock markets become more uncertain. This can help reduce the costs of trading, but more importantly it allows us to invest on a long-term basis. This means we are not obliged to sell assets at what we consider to be distressed levels to meet investor demands to take their money out.
Having a relatively fixed pool of assets makes it the equivalent of an investment harbour, sheltered from the turmoil of asset inflows and outflows that we might see with an open-ended structure. Staying with this maritime theme, while the storm clouds of a recession are building for 2023, the Diverse Income Trust is well positioned in our view to keep sailing on its course of good and growing income generation.
