Fund Research

Chelverton UK Dividend Trust

Last update 05 August 2019

This is independent research. The analyst who has prepared this research is not aware of Kepler Partners LLP having a relationship with the company covered in this research report and/or a conflict of interest which is likely to impair the objectivity of the research and this report should accordingly be viewed as independent.

Summary

Investment objective

The investment objective of the Company is to provide Ordinary shareholders with a high income and opportunity for capital growth...

As at:

30/07/2019

Group/Investment

Chelverton UK Dividend Trust

Ticker

SDV

Management Company

Chelverton Asset Management Ltd

Manager Name

David Horner; David Taylor;

Association of Investment Companies (AIC) Sector

UK Equity Income

12 Mo Yield

5.3%

Dividend Distribution Frequency

Quarterly

Latest Market Capitalisation

£35,549,250

Latest Net Gearing (Cum Fair)

59%

Latest Ongoing Charge Ex Perf Fee

1.98%

Turnover Ratio

21.2%

Shares Outstanding

20,850,000

(Discount)/ Premium (Cum Fair)

-14.3%

Daily Closing Price

170.5p

Chelverton UK Dividend Trust (SDV) is first and foremost an income fund offering quarterly dividends in excess of inflation over the medium to long term. The company also aims to provide investors with the opportunity for capital growth after providing a return that is sufficient to repay the zero-dividend preference (ZDP) shares.

At the helm of the portfolio are lead manager David Horner and co-manager David Taylor, who look for companies with a prospective dividend yield of at least 4% and sit outside the FTSE 100. The team specialises in the mid and small-cap income space and, according to Morningstar, have 70% of the portfolio in micro-cap stocks and a further 27.6% in small caps. The average company size in the portfolio sits at just £191m.

The trust currently yields 5.3%, considerably more than the weighted average in the UK Equity Income sector, which yields 3.9%. From this financial year (2020), dividends will be paid equally across quarterly interim payments, and the board anticipates paying a total of 9.6p for the current year. At the current share price, this equates to a yield of 5.5%. The board has also announced that once the trust’s revenue reserves are equal to double the historic dividend, the company will stop adding to reserves and distribute all further income as special dividends. As at of the end of financial year 2019, the trust had revenue reserves of 19.19p per share, 199% of the expected financial year 2020 annual dividend.

Alongside generating strong income, long-term performance figures for the trust have been exceptional. Over a ten-year period, the trust has delivered 375% in NAV total returns, considerably more than the MSCI UK Small Cap sector, at 256.5%, the AIC UK Equity Income sector, at 205.8%, and the IA UK Equity Income sector, at 149.3%. With this said, returns have been rocky over the medium and short term. Much of this is due to the trust being highly geared through ZDPs, which has meant that the corrections in 2016 and 2018 hit the trust particularly hard. Since the start of the year, the trust has generated a NAV total return of 5.7%, trailing the benchmark and peer group by some margin, which returned 16.8% and 14.6% respectively.

Currently the trust trades on a discount of 14.3% compared to the UK Equity Income sector weighted average of 4.6%

Kepler View

As an income fund, the trust offers investors an extremely attractive yield. Currently sitting at 5.3%, this is much higher than the weighted average in the UK Equity Income sector’s yield of 3.9%. However, the most interesting feature, at least for us, is the diversified nature of the income relative to peers. As we mentioned in our recent article, ‘Income but not how you know it’, the majority of the UK Equity Income trusts are highly concentrated in a few big names. Just eight companies make up more than the 50% of the yield of the FTSE 100, according to Bloomberg figures, and the likes of Shell, BP and GlaxoSmithKline feature 17, 14 and ten times in the top five holdings across the 24 trusts in the UK Equity Income sector. This is particularly worrying when one considers that many of the largest yielders in the index have an uncertain future, and there are question marks over the sustainability of their dividends. As such, Chelverton has the capacity to offer an interesting way of diversifying one’s sources of income and resolving the problem of concentration in the UK Equity Income sector. In the case of this trust, this can be done without sacrificing the level of income and at an extremely attractive discount of almost 16%.

bull bear
Strong long-term track record
High charges
Offers diversified income through small and mid-cap companies
Poor recent performance
Historically and relatively wide discount
Risky due to high levels of gearing

Portfolio

The managers look for companies that generate cash on a sustainable basis, which is then used to grow the business and to reward shareholders. Balance sheets are tested to ensure that a company is not overwhelmed by debt and that the working capital requirements are not too onerous. Sales growth and margins are examined, which they believe will then likely translate into dividend growth. The managers also look to meet with the management teams before investing, hoping to identify those that strike an appropriate balance between current and future income. Once the managers are happy with a company’s propensity and capacity for dividends, the team sets a target yield to determine when they will buy a stock. The company will only invest in a company for the first time if it yields at least 4% on a twelve-month view.

market cap breakdown


% of portfolio
No of stocks
Above £1bn
5.71
4
£500m-£1bn
20.60
11
£250m-£500m
18.90
13
£100m-£250m
19.995
16
Below £100m
34.84
30
Cash and Income
0.00
0
Total
100.00
75

Source: Chelverton Asset Management

When looking to construct the portfolio, the managers have a risk management framework they work to, including:

– Aspire to below 20% for the top 10 holdings
– No more than 5% of the capital value in any one company
– No more than 5% of the income contribution from any one company
– Less than 20% in any single sector

The end result is a portfolio of 75 holdings diversified across a broad range of sectors and industries. The managers look at the companies on an industry basis and the fact the portfolio is exposed to 23 different industries illustrates the diverse nature trust. As can be seen below, the largest exposures come from construction and building materials (14%), support services (10.5%), and speciality and other finance (7.8%).

industry exposure

Construction & Building Materials
14
Support Services
10.5
Speciality & Other Finance
7.8
General Retailers
7.5
Real Estate
7.1
Industrials
7
Insurance 6.9%
6.9
Media & Photography
4.4
Oil & Gas
4.1
Investment Companies
3.7
Software & Computer Services
3.5
Leisure, Entertainment & Hotels
3.5
Transport
3.1
Housing Goods & Textiles
2.7
Automobiles
2.5
Engineering & Machinery
2.3
Financial Services
2.1
Diversified Industrials
2
Restaurants, Pubs & Breweries
1.7
Electronic & Electrical Equipment
1.2
Packaging
1.1
Food Producers & Processors
0.7
Distributors
0.7

Source: Chelverton Asset Management


Gearing

The company’s shares are geared by the zero-dividend preference (ZDP) shares. They were recently re-issued in January 2018 when shareholders of the previous issue received their final entitlement in full. The new class of ZDPs will mature on 30 April 2025, and currently make up close to 20% of NAV. ZDP shareholders will be entitled to receive 133.18p per share, equivalent to a return of roughly 5.3% a year on the £14.5m issued. As we touch on in the performance tab, this means that the trust is not without risks; however, this structural gearing can produce exceptional outperformance during periods of strong performance.

Returns

Long-term performance for the trust has been exceptional. Over a ten-year period, the trust has delivered NAV total returns of 375%, considerably more than the MSCI UK Smaller Cap index (256.5%), the AIC UK Equity Income sector (205.8%), and the IA UK Equity Income sector (149.3%). In fact, the trust has dramatically outperformed the AIC UK Smaller Companies sector (301%). Over this time period, the trust has generated double-digit levels of alpha, at 11.12%, the second highest of the 26-strong UK Equity Income sector. All the while, the trust had the third-lowest standard deviation (14.58%), and the second-lowest beta (0.34). With this said, due to the large number of micro-cap companies, volatility and beta will be biased down as the shares are traded less regularly.

returns

Source: Morningstar

However, for the same reasons that the trust has performed exceptionally over the longer term, it has struggled in more recent times. As can be seen in the five-year graph below, the high levels of gearing through the ZDPs mean the trust has over-reacted to each rise and fall in the market relative to the benchmark and peers. For example, in the month of June 2016, when the European Union membership referendum too place, the trust fell by 12.4% in NAV total returns. In comparison, the benchmark lost 6.6% and the UK Equity Income peer group gained 1.3%. Similarly, the correction over the second half of 2018 saw the trust lose 22% in NAV total return terms. In comparison, the MSCI UK Small Cap lost 17.8% and the peer group 11.8%.

performance vs indices

Source: Morningstar

Since the start of the year, the trust has continued to struggle in the volatile market conditions. Over the seven-month period, the trust has delivered NAV total returns of 5.7%, trailing the benchmark return of 16.8% and the peer group return of 14.6% by some margin. This has largely been due to the portfolio’s domestic bias, along with the fact it has been the high-growth and low-yielding stocks that have had the real upward price momentum. Additionally, the trust’s large domestic exposure has impacted performance given the increasing possibility of a no-deal Brexit. However, the managers believe that, regardless of the outcome, investors will once more refocus on company fundamentals and cash flow once the uncertainty subsides, thus benefiting the trust.

2019 performance

Source: Morningstar

Dividend

The key aim for the trust is to deliver high income for investors through a portfolio of mainly small and mid-cap UK companies.

The company recently announced its financial year 2019 dividend of 8.97p – excluding the special dividend of 2.5p – up from 8.46p in 2018. The board has decided to pay four equal interim dividends on a quarterly basis starting this year (financial year 2020). Four payments of 2.40p will make a total 9.60p of core dividend, which would amount to 5.5p on the current share price. The board also announced there could be a special dividend to supplement the final dividend; however, this will be dependent on the level of total dividend revenue received by the company, including any special dividends. Over the past five years, the trust has grown its dividend at a rate of 5.6%, an amount that is 0.6% greater than the sector-weighted average.

In 2019, the board also announced that once the trust’s revenue reserves are equal to double the historic dividend, the company will distribute to shareholders all additional current period revenue as a special dividend. As of the most recent dividend payment in April 2019, the trust had retained revenue reserves of 19.19p per share, which represents some 199% of the expected 2020 annual dividend of 9.60p per share, giving shareholders a certain amount of reassurance that the special dividend will be paid going forward.

dividends

Source: Chelverton Asset Management

Management

At the helm of the trust are David Horner and David Taylor. In 1997 David Horner set up Chelverton Asset Management to provide the investment management for the investment trust now known as Chelverton Growth Trust. In May 1999 he was responsible for launching Chelverton UK Dividend Trust, two funds he still manages. He has also co-managed the open-ended MI Chelverton UK Equity Income fund since its launch. Prior to Chelverton, David qualified as a chartered accountant in 1985 and has held senior positions in Deloitte, 3i Corporate Finance and Strand Partners Limited, with numerous public and private company directorships.

David Taylor joined Chelverton Asset Management in January 2006, offering specialist expertise investing in companies with sub-£1bn market capitalisations. He has co-managed MI Chelverton UK Equity Income Fund and MI Chelverton UK Equity Growth since launch. He also co-manages Chelverton UK Dividend Trust. Prior to joining Chelverton, he spent nearly seven years as head of UK smaller companies at HSBC Asset Management.

Discount

The trust is currently trading at a historically wide discount of 14.3%. Over the past year, the average discount for the trust has been 8.6% and, over the past three years, just 4%. In fact, over the past ten years, the trust has only traded at a wider discount a handful of times and it has often quickly narrowed after this. The board recognises that it is in the long-term interests of shareholders to reduce discount volatility, but believes that the best way to do this over the long term is through performance. With this said, the board will buy back shares should they feel it necessary.

Relative to peers, the current discount is also wide. The weighted average discount in the AIC UK Equity Income sector is 4.6% and only two trusts are trading wider than SDV. Even the AIC UK Smaller Companies sector, which has faced many of the problems the trust has, is trading at a weighted average discount of 10.6%, and only two constituent trusts are trading at wider levels.

discount

Source: Morningstar

Charges

Chelverton UK Dividend Trust has comfortably the highest ongoing charges fee (OCF) in the sector, at 1.95%. The sector-weighted average is 0.62%, with only three trusts above 1%. With this said, the trust is considerably smaller than the rest of the companies in the sector, with net assets of £42m, and therefore doesn’t benefit from economies of scale like many others. The management fee for the company is 1% of gross assets and the trust has no performance fee.

The KID RIY for the trust is 3.76 relative to a sector weighted average of 1.16. With this said, calculation methodologies can vary across companies.


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This report has been issued by Kepler Partners LLP for communication only to eligible counterparties and professional clients as defined by the Financial Conduct Authority.  Its contents may not be suitable for and are not to be communicated to or be relied on by retail clients. It is not an indication as to the suitability or appropriateness of investing in the security or securities discussed.

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