Diverse Income’s results for the financial year ended 31 May 2022 show it delivering a return on NAV of -3.4%, some way behind the +4.7% return generated by the Numis All-Share Index. A widening discount left shareholders with a return of -10.5%. The board views the recent widening as temporary but remains willing to use its share buyback authority should a wide and anomalous discount persist.
Dividends totalled 3.9p, up from 3.75p for the prior year, and covered by earnings of 4.0p.
The chairman notes that the Numis Small Cap Plus AIM Index (excluding investment companies) returned -9.5%. The weakness of sterling boosted the returns of larger UK quoted companies, which earn most of their earnings overseas, hence the unusually wide disparity between the returns on the UK market as a whole and those of smaller companies. Consequently, the company’s exposure to smaller companies was a relative headwind this year, having boosted returns the previous year.
New downside protection
The chairman says that, although some of the causes of inflation are not responsive to higher interest rates (for example the shortage of oil and gas production, disruption to trade with China and the impact of the Russian invasion of Ukraine on food prices), high global levels of inflation have left central banks with no alternative to raising rates in order to reduce demand, even at the risk of a recession. Given these risks, the company’s manager has recently purchased a FTSE 100 Put Option covering the period to December 2023, replacing the Put Option purchased in 2021 which was due to expire in December 2022. This provides a degree of downside protection for the company’s assets in the event that economic pressures intensify and lead to a significant fall in global equity markets.
The managers note that:
In general, the valuation of a FTSE100 Put Option is often negatively correlated with fluctuations of the Trust’s portfolio, and most especially at times of major market distress. The Trust has held a FTSE100 Put Option in the past, although as major stock market setbacks happen infrequently, often they decline in value as their term expires. When stock markets do suffer a major setback however, such as during the global pandemic, the valuation of a FTSE100 Put Option can rise to a multiple of its initial cost. This was helpful during the pandemic as it offset, in part, the decline in the rest of the Trust’s portfolio valuation during the year to May 2020.
When Put Options rise to elevated valuations they can be sold, and in March 2020 the Trust’s FTSE100 Put Option was sold, and the cash receipts from the sale were invested in additional equity income holdings at relatively low entry prices. These new holdings boosted the recovery of the Trust’s portfolio as the stock market rose thereafter. Importantly, although the revenue from the Trust’s portfolio fell in the year to May 2020 as many companies cut their dividends, with the new holdings and the extra dividend income they generated, the Trust was in a stronger position to fund a sustained and slightly growing stream of dividends to shareholders over this period.
Whilst investing in FTSE100 Put Options does have advantages during stock market setbacks, it is worth keeping in mind that setbacks happen infrequently, and more often the valuation of a FTSE100 Put Option investment declines over time. To minimise such losses, the Strike price* of the FTSE100 Put Options is typically set at a level somewhat below the FTSE100 trading level at the time of purchase.
Over the year to May 2022, a FTSE100 Put Option was purchased early in the period. Although the Trust’s portfolio has declined in value over the year, this trend hasn’t been reflected in the fluctuations of the FTSE100 Index. Overall, the valuation of the FTSE100 Put Option has reduced during the year as its term has reduced and the FTSE100 Index was a lot more resilient than the portfolio, and indeed than most other mainstream stock market indices.
Recently, during July 2022, the FTSE100 Put Option with a term to December 2022 was sold, and a new FTSE100 Option with a term to December 2023 was purchased. To moderate its potential cost were the FTSE100 Index to continue to be resilient, this new FTSE100 Put Option has a lower Strike price of 5,700 rather than 6,200 previously. Of course, if interest rate increases were to precipitate a global recession, and global stock markets such as the FTSE100 Index were to become much more unsettled, then the valuation of the new FTSE100 Put Option might appreciate in a similar manner to that of March 2020. With the new FTSE100 Index Put Option, the Trust’s portfolio would benefit were the FTSE100 Index to suffer a major setback prior to December 2023, rather than prior to December 2022 as previously, albeit that the new option comes at a higher cost given its longer term.
Extract from the managers’ report
The share prices of the largest UK quoted companies that have a majority of their businesses overseas, greatly outperformed most other UK-listed stocks over the year to May 2022, in part as their earnings are enhanced when sterling is weak. Hence, over the year to May 2022, the NAV total return of the Trust declined by 3.41% which compares with a rise of 4.74% for the Numis All Share Index over the same period. The equity income bias of the Trust’s portfolio did continue to add value relative to other strategies however, and the Trust greatly outperformed the return of the Numis Small Cap Plus AIM Index (excluding Investment Companies) which declined by 11.67% over the year.
Although global equity markets have been quite unsettled over the second half of the year under review, in fact the largest detractor to portfolio return in the period was the FTSE 100 Index Put Option, as it bucked the global asset market trend. After a very strong period of outperformance last year, the Trust’s holding in CMC Markets was trimmed, and in the year to May 2022 its share price has fallen back. Hence, whilst CMC Markets was the second worst detractor to portfolio return in the period under review, it still remains the second best contributor over the two years to May 2022. Meanwhile, it still remains part of the portfolio given the potential for it to deliver even greater returns in future.
In terms of positive contributions, the Trust’s holdings in Energy were easily the strongest, in aggregate adding 4.0% to the Trusts returns over the year, with i3Energy adding over half of this total. The second best contributor was Utilities as the portfolio holdings in both Drax and National Grid contributed over 1.0% to portfolio return between them.
DIVI : Small cap bias drags down Diverse Income