Two cheap shares I am backing to bounce back

It has been a bruising year to be investing in UK smaller companies. In this interview, Diverse Income (LSE:DIVI) investment trust fund manager Gervais Williams names two shares caught up in the wider sell-off that he’s backing to deliver the goods over the long term. He also names one of his favourite dividend shares, and explains why investors should continue to back equities despite the income on both bonds and cash rising in 2022. 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: So, Gervais, you invest across the UK market in large, mid-, and small-cap, as well as having exposure to AIM. So, what's the current split, and how has the portfolio fared this year?

Gervais Williams: The underlying feature of the fund is that we invest for companies which generate good and growing income, and the underlying good and growing income within the fund has continued to come through just as we expected.

Clearly, valuations have come down considerably, not just the mainstream stocks, but as you mentioned, many of the smaller quoted companies, the AIM-listed companies. The fund has about a third of the fund in AIM-listed companies, income stocks, which are generating good and growing income. It's probably got about 25%, 30% in mainstream FTSE 350 companies and the rest in other companies. So, it's quite well spread across the different areas, but the NAV (net asset value) has come down quite a bit this year relative to other funds, which tend to invest in the very largest companies that have held up much better.

Kyle Caldwell: And going forwards, how would you assess the valuations of the underlying companies today?

Gervais Williams: Well, what's interesting is the underlying companies themselves are continuing to report relatively good profits. They continue to grow dividends, which is important. And one of the ways of looking at valuations is to look to the price, the assets on the balance sheet relative to their market capitalisations. And these have fallen considerably - it's very unusual to see a price-to-book ratio below one. The fund is currently standing on a ratio around 0.8%, which is incredibly low. And hopefully if these companies continue to succeed, there's plenty of recovery potential in future.

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Kyle Caldwell: And that valuation measure, the price-to-book that you've just mentioned, how does that compare over the 10 years the trust has been in operation?

Gervais Williams: That's right, if you look at the mainstream UK market, it's about 1.5%. If you look at some of the US assets they're over 4%, 5%, sometimes 6%, although they've peaked out now. So, the valuations in the UK are low in themselves. The valuation of the fund is unusually low, normally it's around the average of the UK stock market. As I say, it's well below that now, which is very unusual in our case.

Kyle Caldwell: You have a put option in place on the FTSE 100 index, which seeks to profit from when that index falls. Is that put option still in place? And I assume it's not a position that's paid off this year?

Gervais Williams: That's right, we have had a put option in the past. We had one at the end of 2019 going through the Brexit period. What happened, of course, with 2020, we had the pandemic in March 2020. As the FTSE came down to about 5,000, the value of the put option rose. It's only covering 40% of the fund, not 100%. But it meant that the asset rose to become a multiple of the original costs. It wasn't so much that it protected some of the asset loss during the period of setback, but most particularly it meant we could take profits and reinvest that cash in new holdings at low valuations for upside potential.

Now, after the March 2020 pandemic period, the cost of the put option was too high. And for the following one and a half years, we didn't have a put option because it was just the cost of its decay over time. If it doesn't come through, then ultimately it detracts from performance, which was just too high.

We have had the put option back in the portfolio for just over a year now. Yes, it has cost money, it's cost a bit over 1% in the period since we reinstated it. It was due to expire at the end of this year, December 2022. And in the last couple of months, we have extended that term through to December 2023.

So, what it's there for is if the markets get really unsettled, if the FTSE doesn't hold up as well as it has up to now, then like the March 2020 pandemic, then it will start to rise in value. Clearly the other 98% of the fund is invested in companies generating income, good and growing income and if the markets do recover, if small companies outperform large companies, if the UK itself starts to outperform versus international stock markets, then of course a put option would expire worthless. But the rest of the portfolio will continue to deliver hopefully very attractive returns.

Kyle Caldwell: And given the sell-off that's taken place among UK smaller companies this year, has this thrown up plenty of buying opportunities, what have been the newest names to enter the portfolio?

Gervais Williams: Yes, valuations have come down considerably and the opportunity to buy companies at what we consider to be much lower and attractive valuations has been excellent. Strange enough, we haven't needed to buy many new holdings. We're very excited by the companies we've got in the portfolio, the range of companies. We haven't really got involved in this recovery potential from the consumer sector. It's still lightly invested in consumer sectors. It's invested right the way across other parts of the market, perhaps including some of the oil companies, including some of the companies involved in the financial sector, which is the largest sector in the portfolio. We've been able to top up some of those holdings rather than buying new holdings for the portfolio because they themselves have come to low valuations. And we believe they are some of the best companies out there in terms of recovery potential as well.

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Kyle Caldwell: Could you give us some stock-specific names of companies you’ve been topping up that were already part of the portfolio?

Gervais Williams: Yes, if you look at, say, one of the advantages of things like the construction industry, it is that they tend to have quite long order books. So, it doesn't matter quite whether the forthcoming UK recession is slightly shorter or longer than people think.

So, for example, a company like Galliford Try Holdings (LSE:GFRD) has been in the portfolio. What's unusual about Galliford Try isn't just that it's generating profits, it's paying dividends, growing quite nicely. It's got a very big order book, but its valuation in the UK stock market is below the cash balances on its market capitalisation, so its cash balances exceed its market capitalisation. This is a most unusual feature about companies in the UK. One, it means that hopefully the company is resilient and if there are setbacks it will be strong. But most particularly, when it does generate surplus cash and it is able to pay dividends, it can pay not just good dividends, but grow its dividend rate at a much faster rate. So, there's a company, for example, on a price-to-earnings (PE) of less than 10 in the portfolio, which we're very keen on.

Another example might be Kenmare Resources (LSE:KMR), which is a business involved in titanium dioxide. It has a mine in Africa, [and] it exports titanium dioxide around the world. About 7% of the entire world’s supplies, used mainly in the paint markets. The whitening agent in paint, clearly paint is likely to be a stable market, again, it's trading very strongly. It's made a lot of profit. It's paying a very attractive dividend. Valuation of less than three times PE ratio, according to Bloomberg. But most particularly, again, the share price hasn't really moved. So, these companies are, in our view, extraordinarily overlooked. And if anything, there's a great range across different sectors to diversify risk. So, these are the kinds of things which we think are, not just attractive at this point, but hopefully will deliver not just good dividend growth, but particularly good capital appreciation from here.

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Kyle Caldwell: And while share prices have been volatile this year, dividends have held up well. Could you give a couple of examples of dividend companies you own that have increased their payouts this year?

Gervais Williams: Yes, one of the largest holdings in the portfolio is a company which is involved in, K3 Capital Group (LSE:K3C). It's a portfolio holding which doesn't just help companies, it buys and sells companies for small buyers and sellers. So effectively it's like a corporate finance house, but not for the mainstream, for the tiniest companies, unquoted companies, in the UK, it's trading strongly. It also has an insolvency practice in there, obviously that's good news and so it's increased its dividend quite substantially. It issued some shares back in July, I think, 2020, at about £1.50 [and] this year it's paying out a dividend of 15.5 pence of dividend. So effectively over a 10% yield, clearly the share price has gone up. But these are the kinds of opportunities, it's grown its dividend beautifully over recent years. Good and growing income is the cornerstone of the fund and that's what we're looking for.

Kyle Caldwell: Diverse Income has a dividend yield of around 4.5%. Now, over the past year, we've seen interest rates rise. So, the amount of income that cash is now paying is a lot higher than it has been for several years. Bond yields, they've also been on the rise. So, they're at much more attractive levels than they have been again for several years. So how would you try and convince an investor to back equity income rather than cash or bonds?

Gervais Williams: Yes, I think one of the features of the recent couple of years is that we've seen inflation come up again. I think it will peak in the short term, but I think inflation as a problem is going to be with us for quite some time. And the disadvantage of fixed income, of course, is that they're fixed income. When you've got inflation, they don't go up with inflation.

The great advantage of investing in companies is that their sales tend to rise with inflation, which means that their income, if they continue to exceed, rises with income. It's the good and growing income we believe is going to become not just attractive now, but going forward. We think the UK equity stock market is going to become more important to all asset allocators who want to invest cash-compounding rather than just capital appreciation. So, it's the cash and the growing cash from the portfolio, which is the cornerstone and the reason why we think there'll be growing interest in the sector.

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.