Good stock picking by Diverse Income (DIVI) fund managers Gervais Williams and Martin Turner saw the £238m UK equity income trust outperform the domestic stock market for the first time in four years, but with 31% of investors having recently chosen to sell their holdings, time may be running out for the small-cap focused portfolio.

The latest annual report for the year to 31 May shows the Premier Miton duo achieved a 12.8% investment return to beat the Deutsche Numis All-Share index’s 9.7%. Contributors to this were defence group BAE Systems, online financial trading website IG Group, social housing maintenance group Mears, packaging group Smurfit Kappa and System1, a global market research provider, on which they had all taken substantial profits.

That follows a 15.4% increase in DIVI’s net asset value (NAV) in the previous 12 months that was essentially in line with its UK benchmark. That was preceded by two years of losses in the aftermath of a 38.4% rebound from the 2020 pandemic crash.

Chair Andrew Bell said the 2024/25 return was a good result given that smaller companies and AIM stocks continue to lag the wider market, although he said there were signs of growing international investor interest in the undervalued asset class after a four-year exodus by UK investors.

Shares’ re-rating delivers 21% return …

Including 4.5p of dividends that were covered by earnings and up 5.9% from last year, shareholders enjoyed a 20.8% total return as the shares ran ahead of the portfolio and narrowed the gap between their price and the net asset value of DIVI’s investments from 9.6% to 3.5%.

That in turn reflected the recent improvement in sentiment towards UK shares as investors move some of their money out of the richly-valued US stock market in response to Donald Trump’s erratic administration.

The sense of a gathering rebound in neglected UK equities raises the prospect the trust, which holds a diversified pool of 100 stocks, could claw its way up from close to the bottom of its sector.

Over five years, DIVI stands in the fourth quarter of the 19-strong UK Equity Income peer group with a total shareholder return of 44%. The average return is 72% with the leader, Temple Bar (TMPL) notching up an impressive 171.5%, while former sector leader Finsbury Growth (FGT) has tumbled to last place with a niggardly 15.8%.

… but another 31% of shares redeem

Time may not be on DIVI’s side, however, with net assets set to slump to around £180m from £257m after holders of 30.8% of the shares last month elected to sell in the latest annual redemption point.

Allowing investors a regular chance to withdraw their money at asset value is good governance and an effective way of managing the share price discount. However, with UK smaller companies out of favour it has contributed to the portfolio declining from over £427m three years ago.

Another hefty redemption next year could shrink DIVI to a size where it slips off the buy lists of big wealth managers which will make efforts to stoke up demand and narrow the discount more difficult.

Premier Miton last year saw the Miton UK MicroCap (MINI) trust that Williams and Turner also ran throw in the towel after it became unviable after a series of big annual redemptions. There’s a risk the same fate could befall the larger DIVI which is why Bell, the former chief executive of Witan investment trust before its merger with Alliance Trust to create Alliance Witan (ALW), is emphasising the potential turning point that could make this a good time to invest.

“Whilst everyone should do their own research, our managers believe that valuation, fund flows and fundamentals are particularly well aligned to reward our investors in coming years, with outperformance resuming more recently, after the uncertainties spanning the Brexit process, the Covid crisis and the peak in the US tech boom, all of which led investors to focus elsewhere,” Bell said.

Time to go against the herd?

Since the financial year-end in May, DIVI’s net asset value has eased back 1% and the shares have slipped 8.6% below NAV after the redemption decision two weeks ago. That is wider than the 3.8% average discount in its sector, which means investors prepared to go against the herd could get an attractive entry point for any further recovery in UK financial, mining and industrial stocks as appetite for US mega-cap tech stocks has begun to wane.

Of course, there are many UK smaller company funds and trusts to choose from to do this. Williams and Turner argue their equity income approach to pick cash-generative companies is well placed should there be a squeeze on corporate profits as central banks contend with excess inflation and deflation in coming years.

“The bottom line is that in contrast to much of the period to date, we believe the trust’s strategy will be the beneficiary of a strong market tailwind in future. Furthermore, if we can continue to add further value via careful stock selection, then the trust’s investment case appears to be immensely strong. We believe it is the best we have seen for thirty years,” they said.