David and Goliath is a wonderful Biblical story but in the investment trust world you rarely find a plucky, small upstart cutting the big guys down to size.
However, recent years has seen a giant killer emerge in the core UK Equity Income sector where the £58 million Chelverton Small Companies Dividend Trust (SDV) has successfully taken on bigger opponents like Mark Barnett’s Edinburgh (EDIN) and Job Curtis’ City of London (CTY), which both boast assets of over £1.6 billion.
Over one and five years Chelverton, which is chaired by former chancellor Lord Lamont, has delivered total returns for its ordinary income shareholders of 38% and 245%, miles ahead of the 11% and 74% averages mustered by the rest of the field.
Only the £1.2 billion Finsbury Growth & Income (FGT) trust has been able to compete with the sprightly small fry. Although Finsbury’s five-year return of 117% looks a bit feeble in comparison to Chelverton, it actually places Nick Train’s fund in second place in the 25-strong Association of Investment Companies’ grouping.
You have to stretch back ten years - to just before the start of the financial crisis - to see the situation reverse. Over the decade Finsbury tops the sector with a 212% total return, knocking Chelverton into second place with a much smaller gain of 140% reflecting two appalling years in the credit crunch when it sank 30% in 2007 and crashed a further 64% in 2008.
All out for income
That seems a long time ago for Chelverton, whose impressive performance since 2009 has caught the attention of private investors, particularly those on the Alliance Trust Savings platform who own 8% of the stock, according to Thomson Reuters.
The total returns don’t tell the whole story though. Notwithstanding its focus on smaller companies under £500 million, this is an out-an-out income fund, only buying stocks when they offer a forward yield of at least 4% and selling them when the yield drops to 2%.
Although lacking the decades-long dividend growth records of some of its larger rivals, it has grown payouts for the past eight years, with annual dividend growth averaging 5% since 2012, according to the AIC, topped up by special additional dividends when possible. It has also steadily accumulated revenue reserves which, in the last financial year to 30 April, covered the quarterly dividends by 1.7 times.
Growing investor demand for this new dividend champion has in the past 14 months pushed the trust to a premium over net asset value on several occasions, enabling the company to issue new shares.
Even so, that growth has not bulked up this contender sufficiently to force it on the buy-lists of big wealth managers who increasingly view any trust below £100 million, if not £200 million, as too small and illiquid to trouble with.
David Horner (pictured), the lead manager who has been in charge of the Chelverton portfolio since launch in 1998, has an opportunity to put this right when the investment trust refinances in January.
Horner hopes its great track record and focus on small, high-yielding stocks - which marks it out from the blue chip bias of most of its bigger rivals - could convince wealth managers to invest a lot more money when it reconstructs for a new seven-year stretch.
‘I want to raise £10 million from each of the six big wealth managers to get over £100 million,’ Horner said.
One perception problem for Chelverton may be its ‘split capital’ structure which means it has two share classes with 9.3 million zero dividend preference shares standing alongside 17.3 million ordinaries. The ‘zeroes’ wind up in three months at which point they will receive back capital equivalent to 6% growth a year. They have received no dividends during their lifespan, however, effectively loaning their income to the ordinary shareholders.
Those with long memories will recall the ‘splits crisis’ of 2001 when many highly-leveraged split trusts with holdings in other indebted splits collapsed after the dotcom bubble burst. Chelverton does not invest in other investment trusts and has no bank debt so the danger of that sort of contagion reoccurring does not exist.
Nevertheless, it is relatively highly geared with structural borrowing equivalent to 18% of assets. This looks high at a time when other UK equity income funds have responded to stock markets’ advance to all-time highs by cautiously reducing their gearing to an average of 7%.
Smaller companies not expensive
That doesn’t sound great for investors wary of stretched valuations. Horner counters that while FTSE 100 stocks may look expensive, the same cannot be said for the small, less well-followed income and growth stocks he specialises in.
‘There are a number of FTSE 100 stocks that are extremely overvalued but that isn’t my market place.
‘My sector is certainly not overvalued,’ he said, citing figures showing that at the end of July, his 70-stock portfolio traded on a comparatively modest 12.9 times earnings with an historic yield of 4.3%.
‘The majority of companies in the fund are very small, where there is amazing value but it will take time to be manifested,’ Horner added.
The 15 months since the Brexit vote have been turbulent but positive for Horner and his co-manager David Taylor. The devaluation of the pound led to four companies in the portfolio receiving bids from overseas rivals. Most prominent of these was a £124 million takeout of Avesco, the media services company, which Horner originally bought at 126p per share and ultimately received a 110p special dividend and a 650p exit price. He has spent much of the year redeploying the money into 31 of his holdings.
But he would dearly love to raise more cash, saying the negative sentiment towards smaller, domestic stocks after the referendum has created lots of buying opportunities in companies that are continuing to do well and grow their dividends.
‘I have a record number of stocks that I want to buy but don’t have the cash,’ said Horner.
Post-Brexit analysis by Horner’s team earlier this year showed 73% of the sales of its companies were domestic with 13% into Europe, 9% into North America and 5% to the rest of the world.
UK-centric but diversified
’This exercise merely confirmed what we have been saying since the fund was launched 18 years ago: that it is very “UK-centric” and that the health and growth of the UK economy is the biggest determinant of the success and prosperity of the bulk of the companies,’ said Horner.
That could be a problem if the economy falls into recession but for now Horner is accentuating the positive. The fact that his small-cap search criteria flag up many interesting, good-value stocks underlines the alternative that the fund can offer income investors.
In comparison with its larger rivals who look uncomfortably reliant on a dwindling number of solid, blue chip dividend payers, Chelverton Small Companies Dividend looks very well diversified. While the average UK Equity Income trust has 26% crossover with the rest of the sector, Chelverton’s analysis show it shares slightly less than 7% in common with its rivals. This is the smallest crossover in the sector, he said, just ahead of Finsbury Growth & Income on 7%. That fact is another reminder that this trust arguably deserves to attract more assets to rub shoulders with its better-known and bigger rivals.