Top tactics to find resilient dividend shares

Gervais Williams, fund manager of Diverse Income Trust (LSE:DIVI) investment trust, acknowledges that with the UK entering a recession, some companies “will get caught out”. In this interview, he explains the qualities he looks for to find resilient businesses that can continue paying dividends and keep delivering growth during an economic slowdown. He also names a consumer-facing firm that’s well positioned to cope with a recession, picks out an overlooked AIM share, and explains the benefits of the investment trust structure in having a fixed pool of assets. Diverse Income Trust is one of interactive investor’s Super 60 Investment Ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today I have with me Gervais Williams fund manager of the Diverse Income Investment Trust. Gervais, thanks for coming into our studio today.

Gervais Williams, Diverse Income investment trust fund manager: It's a real pleasure.

Kyle Caldwell: Looking ahead to 2023, it's very likely that the UK is going to enter a recession. How will this impact UK smaller companies? Will it be a further sell-off or has that recession already been priced in?

Gervais Williams: Share prices have clearly come down an awfully long way, if we have a recession and I think we will, there will be further downgrades. Some companies will get caught out. So there's room for some disappointment out there. But the great advantage about being a listed company is that, of course, you have a stronger balance sheet typically. Therefore, you can continue, hopefully to invest even when others unfortunately become insolvent and vacate markets. But the best opportunity for quoted companies is that they can acquire other assets which are insolvent.

So, if you think recently, a company called Made.com Group (LSE:MADE) came to the market a few years ago, it was valued at about £700 million at the time. Most recently, unfortunately, it has gone insolvent and Next (LSE:NXT) bought it for about £3.4 million. No doubt there'll be a lot of working capital involved, maybe £25 million. I don't know what the numbers are, but the cash return on that investment, having bought it at such a low value with the working capital, is likely to be particularly attractive. Now that's good for Next and Next's share price hopefully will do well and they get some earnings and some profit as a result of that.

If you're investing in the same acquisition as a small company, if you start at, say, £200 million market cap or even £100 million market cap and you buy the asset, you may raise £30 million to get the asset into your business. But most particularly, the uplift isn't marginal. It can be very substantial. K3 Capital Group (LSE:K3C) is a company which actually announced a couple of acquisitions back in July 2020, which it described [as] transformational for earnings, and that's led to the company not just succeeding but actually generating much greater cash generation and growth than it would have done otherwise. It's very exciting, although it's very troubling for individuals. It's very good for these kinds of companies to actually save the employment and allow that cash invested in the past, to still generate an attractive return for the future.

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Kyle Caldwell: Investor sentiment towards UK funds or UK investment trusts, it is very low. So what needs to happen for that investor sentiment to improve? What are the reasons for optimism?

Gervais Williams: I think we've been in a period where actually the tailwind of globalisation has been wonderful. Basically we have seen valuations moving up and up and up, that's not just bonds, but equities, property and suchlike. So asset valuation has been very good, along with earnings when you've got very low-cost borrowings, most people tend to spend a bit more. So, we've seen profit margins across the corporate world, not just in the UK, but across the corporate world, being very high.

Unfortunately, I think profit margins are going to come under pressure next year. I think we're going to see people being much more price sensitive and I think valuations will be more moderate as well because of inflation. So actually, I think most stock markets won't do extremely well. Going forwards, I think there'll be some little corners of the stock market which continue to thrive. I think the UK stock market itself, I think [is] superbly well-positioned, cash and compounding income is going to become a much more popular strategy relative to capital gain and I think the UK stock market will rise because of that. But obviously small quoted companies, which typically outperform the UK FTSE 100, I think will continue to outperform in the future as well. So, I think the UK, and particularly a multi-cap approach like Diverse Income isn't just likely to continue to generate some attractive returns over the long term, but I think it'll actually generate returns, which are better than most international comparatives. That's a big change, very exciting if it happens.

Kyle Caldwell: And as we head into 2023, are there any sectors or themes within Diverse Income investment trust that particularly stand out for you?

Gervais Williams: I think the key issue is we've got to be investing in companies which are resilient. That means that we need to find companies which have strong balance sheets. Therefore, if they do have a slowdown, if they do get caught out, then, of course, yes, their share price has come down, but they're still in a position ultimately to fund the current dividend and keep the business going in terms of investment going forwards.

So, geared companies I think are going to be much more problematic. Generally, we are quite cautious in the portfolio about investing in companies with lots of debt. So, I think that's an important feature. I think as well, although there will be recovery, I don't think the consumer necessarily will be as buoyant as people hope in terms of recovery. I think it's going to be quite a long period where we get through the cost-of-living crisis.

Companies themselves may have some setbacks. There may be more profit warnings, and it may be that governments continue to run out of money and have to keep raising taxes. So, I think all that implies that actually there's no easy area, but companies that are in a little niche, where they've got market dominance, where they're delivering outstanding levels of service, not good, but outstanding levels of service, will mean they can hold on to margin in the way that a lot of companies that deliver ordinary services won't. So, we've had a long process towards including service levels as one of the criteria for selecting companies for Diverse Income. And hopefully that will settle well through what may be a troubled period.

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Kyle Caldwell: And given your views on consumer spending, particularly as we're about to enter a recession, are you cautious on the more economically sensitive stocks in the market?

Gervais Williams: We are. But I mean, it's interesting because there's still companies in the portfolio that are well positioned even within a consumer setback. They aren't many. We have very low weightings in consumer stocks, but for example, AO World (LSE:AO.), which is a company which is involved in online appliances, its market price which is maybe stable, but they are in a position where they can improve efficiencies enormously and in doing so continue to generate cash. Perhaps competition will be less severe because some of the competitors may find it difficult to finance their business. So it's not generating cash now, but it will be in the future. We expect it to pay very attractive dividends in the future. So, it is in the retail sector. It's a difficult sector, but there's still going to be winners even in the retail sector. So we've got to just be open-minded to the full range of opportunities.

Kyle Caldwell: And as you mentioned, one of the key criteria is customer service.

Gervais Williams: Absolutely. I think it's interesting when you meet companies and go through the presentation, what's interesting is they don't often talk about customer service. And it's been so easy really to do business for the last 30 years that most businesses survive quite happily, even on average service. But we think those companies which are delivering not good, but outstanding service, are important.

Now, we meet management teams and they all say that they're going to deliver outstanding service, but we ask them about the details. How do you measure it? What was it like last month? Have you done any mystery shopping on some of your competitors and that kind of thing? And most particularly, there are some management teams, sadly, who are in [a] little bubble when they make investment decisions or management decisions which are related to them saying this is going to be marvellous. And it makes it harder for the day-to-day people to look after customers.

We want management teams who are really related to the front line of that business, who really care about customer service and actually help frontline staff deliver service, which is very motivating and engaging and helps the frontline staff deliver outstanding service. As I say, I think those who deliver outstanding, as opposed to ordinary service, have a much better chance of holding on to margin at a time when I think margin compression is going to be quite a wide-ranging feature.

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Kyle Caldwell: Around a third of Diverse Income Trust is in AIM stocks. I assume, given the volatility in the market in 2022, that some shares may have been unjustly sold off. Could you give a couple of examples of companies that you think are, the valuations have fallen and they're now at very cheap levels?

Gervais Williams: There's a lot of companies out there which have very stable businesses. If you take Mears Group (LSE:MER), for example. It's a business which actually looks after property for many of the housing associations. It's had a couple of years when not many people wanted to actually have their kitchen replaced in these housing associations. They'd rather put that on hold. They've still been out, repairing the windows, repairing the gas leaks, all that kind of stuff. So they've had a tougher time.

What's been more interesting is they've also got involved in helping asylum seekers, so they're actually looking after many of the hotels where the asylum seekers are. So the underlying business is actually generating profits. It's really well placed for the future. Service levels, I think, are outstanding. So from that point of view, it's overlooked. It is absolutely a small company where you're seeing a low valuation, share price being unfairly low relative to the prospects and the cash generation of it going forward.

So those are the kind of companies and there's quite a range of companies, about 130 holdings in the portfolio. Each one is relatively small in terms of the contribution towards income. But because of that, even when the odd one does disappoint, it means that the underlying momentum of the income continues to come through. And that's actually the cornerstone of what we're trying to achieve.

Kyle Caldwell: And when there's been a market sell-off, as there has been for UK small companies in 2022, how beneficial is it running an investment trust, having a fixed pool of assets, meaning that you don't have to worry about money coming in or money coming out of the portfolio?

Gervais Williams: Yeah, so one of the advantages of investment trusts is actually it's a long-term fund, designed for long-term investors and it means therefore you don't get that sloshing in or sloshing out of investors when things get busy, therefore it reduces cost. But much more importantly, it also allows you to invest on a long-term basis. The portfolio would be constructed on that basis anyway, but it means we haven't had to knock things out, at what we consider to be distressed levels, because we've had some redemptions that day. So it's a much better structure, to be honest. Investment trusts tend to outperform unitised vehicles for that long-term basis. So ultimately, yes, it's a very appropriate structure.

Kyle Caldwell: And finally, a question we ask all fund managers we interview. Do you have skin in the game?

Gervais Williams: Absolutely, I don't have any personal investments other than holdings in my own funds. I do invest in the PLC, Premier Miton itself, but aside from that, all my savings go into my own funds.

Kyle Caldwell: Gervais, thanks for coming into our studio.

Gervais Williams: Thank you very much indeed.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interviews on our YouTube channel where you can like and subscribe. Hopefully, see you next time.