Small caps can be a good source of income: Diverse Income Trust

Diverse Income Trust (DIVI) was launched in April 2011 with the aim of generating an attractive and growing level of income along with long-term capital growth through predominantly UK-listed equity investments. The trust can invest across the market-cap spectrum; however, its managers Gervais Williams and Martin Turner (see Management section) are small-cap specialists, so it is natural that they have given the portfolio a strong tilt towards small caps and AIM-listed stocks (see Portfolio section).

The portfolio has performed very well since inception, beating comparative indices and the Morningstar peer group (see Performance section). However, the turbulent market conditions of recent years have made it harder to outperform with a small-cap bias.

The managers believe that the companies that can generate the greatest long-term dividend growth are also those that can generate the best capital returns. In this regard, many of the stocks in the portfolio, including the small ones, are highly cash generative with strong balance sheets.

The managers tend to avoid ‘unicorn’-type stocks, i.e. those that promise huge future profits but can’t demonstrate cash-generation potential in the near term. This approach has enabled a dividend yield of approximately 4.3%, and the dividends for the last financial year (ending 31/05/2022) were once again fully covered by underlying revenue returns (see Dividend section).

The portfolio is generally run with a small cash balance, which is ready to be deployed when the right opportunities present themselves; the team have therefore not felt the need to use DIVI’s gearing facilities. The board operates an annual redemption facility, which provides a degree of assurance for investors. DIVI has an OCF of 1.05%.

The managers have a thesis that smaller domestic companies and those with shorter-duration cash flows should do better as the world moves away from the globalisation that has highly benefitted multinationals and many of the major technology names.

The managers of DIVI have expertise in running small-cap portfolios and have given the portfolio a heavy tilt to this segment of the market. The turbulent market conditions of recent years have not been kind to this strategy, though, as large and defensive income stocks have held up much better. However, since the launch of the fund DIVI has performed very well, vindicating the managers’ strong bias to small caps and their stock-picking ability.

The managers’ small-cap bias is not as aggressively growth focussed as traditional small-cap investing tends to be, but is arguably more conservative, tending to focus oncompanies with a lower duration, strong cash flows and solid balance sheets. Meanwhile, there are still ‘core’ large-cap income stocks to provide some balance.

We believe that DIVI offers a differentiated approach to income investing and would complement a more traditional UK equity income strategy within a portfolio, giving a good balance between different market-cap sizes.

The portfolio is well diversified due to being spread across 120–130 stocks, having limited weights to individual holdings and also being well spread across sectors. Further risk mitigation is offered through the potential use of FTSE 100 put options, although this is not always an ideal hedge for the portfolio, as evidenced by this year’s market movements.