The Merchants Trust — Higher gearing to take advantage of opportunities

UK stocks have been out of favour with global investors since the Brexit vote in 2016 (Exhibit 1, left-hand side). The discount to the world market started to narrow at the end of 2021 but has since widened during a period of economic and political uncertainty in 2022. Looking at the valuation metrics in Exhibit 1 (right-hand side), the Datastream UK index is currently trading on a forward P/E multiple of 10.3x, which is a c 24% discount to its 10-year average and a c 26% discount compared with the Datastream World index. While the outlook for economic growth in the UK looks unappealing compared with other G7 countries in 2023, over time, with investor sentiment towards UK stocks so low, perhaps there is potential for a relative re-rating. The UK market offers a wide selection of global and domestic businesses, many of which have interesting long-term growth opportunities, and it is well established with robust legal and regulatory frameworks. There is potential for a pick-up in merger and acquisition activity as well-financed overseas companies take advantage of being able to acquire attractively valued UK businesses; this could be supportive for the performance of UK stocks.

Gergel says that we are in a very challenging economic environment because of the spike in inflation, especially in energy prices, which has been exacerbated by the war in Ukraine. This is putting cost pressures on consumers and companies and squeezing their profitability. He suggests that we may already be in recession, so it is a difficult time for businesses. Supply chain disruptions continue, and inventories are high because companies overordered in response to these supply constraints, while currency movements are also adding to earnings volatility. However, the manager opines that a significant amount of these problems is already factored into share prices.

According to Gergel, the UK market is very modestly priced and there is a huge divergence between company valuations. He says that cyclical stocks have derated significantly; however, the outlook for these companies should improve over time. The oil price has come down, freight rates are back close to pre-pandemic levels, while other commodity prices have moderated, so inflationary pressures should ease, although the manager notes that labour costs are rising.

Gergel comments that interest rate expectations have risen in 2022, and the outlook for the pace of higher rates has accelerated. However, the manager suggests that we could be past ‘peak fear’ on interest rate concerns. In response to the former prime minister Liz Truss’s mini budget on 23 September 2022, UK mortgage rates rose above 6% but are now moderating. The UK 10-year government bond yield spiked at c 4.5% on fears that inflation would spiral out of control, but markets are now calmer, and the bond yield has come down to c 3.5%. Gergel suggests that on a six-month view, the investment backdrop could look very different, with talk of when interest rates will be reduced rather than raised. In such an environment, he believes that cyclical stocks could perform relatively better.

The manager says that coming into 2022, global investors were looking more favourably on the UK market given its modest valuation, robust corporate governance structure and being home to a good selection of global businesses. However, the UK’s political instability this year has been a deterrent. Gergel suggests that if the political environment stabilises, there could be more interest in the UK market. Also, given low valuations, the manager anticipates an uptick in the number of acquisitions of UK businesses by overseas companies as economic uncertainty abates.

So far, reports the manager, there has not been the anticipated widespread earnings downturn. He notes that there have been some weaker trading statements from companies in the building sector, with volumes declining but pricing remaining firm. Gergel suggests that investors are essentially waiting for the bad news to hit following a benign Q322 earnings reporting season.

At end-October 2022, MRCH’s top 10 holdings made up 35.0% of the fund, which was a lower concentration compared with 38.0% a year earlier; six positions were common to both periods. The portfolio had 52 positions and its geographic exposure was c 95% UK and c 5% Europe ex-UK. In terms of market cap, the broad split was 60%, 25% and 15% between large caps, mid-caps and small cap/other/cash respectively.

There were modest changes in MRCH’s sector exposure in the 12 months to end-October 2022. The largest increases were industrials (+2.4pp) and consumer staples (+2.3pp), while the largest reductions were utilities (-3.9pp) and consumer discretionary (-2.3pp). The trust’s portfolio is the result of bottom-up stock selection with the largest active weights versus the benchmark being industrials (+5.1pp) and healthcare and basic materials (both -4.4pp).

Gergel highlights one of MRCH’s energy holdings. Energean (ticker: ENOG, £2.2bn cap) is an international exploration and production company with a focus on natural gas. It has just started producing from a very large field offshore Israel that is expected to quadruple the firm’s gas production. Energean has very long-term contracts with downside caps and upside inflation protection, strong cash flow growth and is ramping up its dividend. The manager considers that Energean is a mispriced company that is not well known in the market.

In September 2022, Gergel initiated a position in Grafton Group (ticker: GFTU, £1.78bn cap), which is a leading builders merchant and retailer in Ireland and a major UK distributor under the Selco brand. H122 revenues were split: 42% UK, 37% Ireland, 15% Netherlands and 6% Finland. The Irish economy is resilient, with a shortage of housing and ageing housing stock in need of modernisation. Grafton has a good history of capital allocation and at the time of purchase was trading on a modest 7x forward P/E multiple, with a third of its balance sheet held in cash, providing opportunities for further investment in a fragmented industry. The manager says that its stock price had declined significantly due to general economic concerns, which afforded him the opportunity of buying a very good business at an attractive valuation. MRCH’s remaining holding in HomeServe was sold as its share price approached the level of Brookfield Asset Management’s bid.

In August 2022, Gergel added NatWest Group to MRCH’s portfolio to increase its exposure to interest rate-sensitive stocks. Since the 2007–08 global financial crisis, the banking industry has become highly regulated and bank balance sheets are stronger. The manager explains that NatWest operates in an oligopoly and its legacy issues are being resolved. Gergel is not too pessimistic on the outlook for the UK economy and considers the bank well provisioned with a solid lending book, while it is benefiting from higher interest rates.

The manager reports that, over the last few months, he has been increasing MRCH’s cyclical exposure due to the wide valuation dispersion within the UK market. Additions include to real estate, financials, construction and retail stocks.

MRCH’s relative performance is shown in Exhibit 6. Its NAV and share price total returns are ahead of the benchmarks’ over the last one, three, five and 10 years. The trust’s outperformance is particularly notable over the last decade.

Gergel comments that it has been difficult to beat the market over the last 12 months. MRCH has benefited from not having a significant underweight in energy stocks, which have performed well, while its overweight exposure in tobacco stocks has been an important contributor to the trust’s performance. Shares in Imperial Brands and British American Tobacco have appreciated due to the companies’ defensive qualities and attractive valuations. Also, Imperial Brands launched a £1bn share repurchase (c 5.5% of the share base), which was welcomed by investors. The manager also highlights that defence and mining stocks have performed well, and banks have done relatively well in a lacklustre market. Some investors have avoided these businesses on ESG grounds, but they are represented in MRCH’s portfolio. The largest detractor to the trust’s performance over the last 12 months was not having a position in AstraZeneca, which has benefited from pipeline successes. Gergel stresses that he must have a positive investment case on a company before it is included in the portfolio, and this was not the case for AstraZeneca.

There are 21 funds in the AIC UK Equity Income sector and in Exhibit 8 we show the 17 largest with market caps greater than £100m. MRCH has a commendable performance track record, with its NAV ranking first over the last five years, second over the last three years, third over the last 12 months and fifth over the last decade. On 19 December 2022, MRCH was one of five funds in the selected peer group trading at a premium to NAV. The trust has a competitive ongoing charge, ranking sixth and, in line with its peers, no performance fee is payable. MRCH has an above-average level of net gearing and offers the third-highest dividend yield in the selected peer group, 0.7pp higher than average.

MRCH has grown its dividend for the last 40 consecutive years, compounding at a rate considerably higher than that of UK CPI inflation, and consistently offers a higher dividend yield than the broad UK market (Exhibit 10). Distributions are made quarterly in August, November, February/March and May.

Gergel is encouraged by the improvement in the trust’s income following COVID-19 weakness. The FY22 dividend of 27.3p per share was 0.94x covered, whereas the FY21 dividend was just 0.68x covered, and the prospects for further improvement look bright. As examples, NatWest Group has recently announced a not-inconsequential special dividend of 16.8p per share and IG Group Holdings increased its dividend for the first time since 2018.

At the end of FY22, MRCH had 16p per share in revenue reserves, which is equivalent to c 0.6x the FY22 dividend. So far in FY23, two interim dividends of 6.85p per share have been paid, which are 0.7% higher year-on-year. Based on its current share price, the trust offers a 5.0% dividend yield.

MRCH’s 1.8% share price premium to cum-income NAV compares with a range of a 2.7% premium to a 2.2% discount over the last 12 months. Over the last one, three, five and 10 years, the trust has traded at average premiums of 0.8% and 0.6% and average discounts of 0.5% and 1.8% respectively.

The board’s policy is to issue new shares when MRCH’s shares are trading at a premium to NAV with debt at market value and to consider repurchasing them when they are at a sustained discount to NAV. As shown in Exhibit 12, share issuance has accelerated meaningfully in FY23; so far c 11.8m shares (c 9.2% of the share base) have been issued, raising c £65.5m.

MRCH was launched in 1889, and as such is one of the oldest investment trusts listed on the London Stock Exchange. Since 2006, MRCH has been managed by AllianzGI’s chief investment officer for UK equities, Simon Gergel, who has c 35 years of investment experience. He aims to provide an above-average level of income and income growth, together with long-term capital appreciation from a high-conviction portfolio of mainly higher-yielding large UK companies.

The trust’s portfolio is relatively concentrated, with c 40–60 stocks, and Gergel has a contrarian approach, seeking undervalued equities that can be held for the long term. MRCH’s performance is measured against the broad UK market (prior to the end of January 2017 it was versus the 100 largest UK companies). Investment guidelines are in place to mitigate risk. MRCH must have exposure in at least five of the 11 market sectors, with a maximum 35% of the fund in a single sector. Any holding may not exceed 15% of assets. Gearing in a range of 10–25% of NAV, at the time of drawdown, is permitted; at end-October 2022, net gearing was 13.1%.

MRCH has a distinguished dividend history: it has increased its annual distribution for the last 40 consecutive years, using reserves to supplement income when required. MRCH currently offers an above-market dividend yield of 5.0%.

Gergel focuses on undervalued companies with strong fundamentals, aiming to generate a high – and rising – income stream and long-term capital growth. He says that there is compelling historical evidence that, on average, companies paying high dividend yields have delivered above-average total returns, not just a higher income stream. The manager is able to draw on the broad resources of AllianzGI’s investment team, which includes equity, credit and macroeconomic research analysts, ESG specialists, and the proprietary Grassroots market research operation.

Companies considered for inclusion in the portfolio undergo thorough fundamental research with a particular focus on the sustainability of a firm’s cash flows. Stock selection is centred around three pillars: fundamentals (focus on a company’s industry structure and competitive position, its financial metrics and ESG factors); valuation (in absolute and relative terms, along with dividend yield); and themes (industry and secular issues, the macroeconomic outlook, and the stage of the business cycle.) There are three investment categories represented in MRCH’s portfolio:

Positions may be sold if they become fully valued, there is a change in the investment case, or a better opportunity is identified.

The consideration of ESG factors is fully integrated into MRCH’s research process along with more traditional operational and financial analysis. By understanding how a business interacts with the environment, treats its employees and deals with customers and suppliers, the manager and his team can gain valuable insights into its future prospects, and can assess long-term risks, which might not be evident in financial metrics. Companies with a low score on any ESG factor are sold or need a documented justification from the manager. The process is monitored by regional CIOs and AllianzGI’s sustainability team.

AllianzGI believes that it has an important duty to engage with the boards and management teams of MRCH’s investee companies and to regularly submit proxy votes. This is not purely about holding management to account, but also about influencing company strategy and promoting effective governance, to help improve long-term performance. Working with investee companies, sometimes in conjunction with other shareholders, helps engender real change and make a positive difference to society. AllianzGI sees ESG as a distinctly different philosophy from socially responsible investing, where investment universes are explicitly constrained to avoid ‘bad companies’ so that portfolios can be skewed toward ‘good companies’. It believes that ESG risk, once properly understood, should be considered in the context of risk/reward, like all other risks considered by the manager. Furthermore, AllianzGI believes that third-party ESG/SRI research is too dependent on limited company disclosures. Therefore, its analysts and managers challenge third-party research, developing their own conclusions based on material risks.

Recent ESG discussions include with power generator Drax Group about its sourcing and use of biomass following a Panorama investigation. Meetings with IG Group Holdings have centred around corporate governance and the company’s capital allocation, having asked investors for their input. IG Group has subsequently issued a clear policy on returning cash to shareholders, which includes a progressive dividend and share repurchases; this development has been well received by shareholders, including AllianzGI. Discussions with tobacco companies include environmental issues such as the control of deforestation, and the use of children on tobacco farms, with a commitment to eradicate the practice at farms supplying British American Tobacco by 2025.

At end-FY22, MRCH had c £93m of debt with an effective interest rate of c 3.7% (considerably lower than 8.5% at end-FY17). Net gearing at the end of October 2022 was 13.1%, which is within the board’s policy range of 10–25%.

Recently, the remaining £16m of MRCH’s £42m revolving credit facility was drawn down, which increased its net gearing from c 13% to c 15%. This indicates that Gergel sees good value in the UK market and illustrates the board’s confidence that the manager will be able to generate annual total returns above the trust’s low single-digit cost of debt.

MRCH’s active share issuance, in response to high investor demand, has reduced the trust’s net gearing over time. As a reminder, at the end of January 2020, gearing was reduced to c 15% by repaying £16m of MRCH’s revolving credit facility. Bringing the trust’s net gearing back up to this level enhances MRCH’s potential income generation and provides the board with extra flexibility in terms of the trust’s own dividend payments.

AllianzGI is paid 0.35% pa of the value of MRCH’s gross assets (minus current liabilities, short-term loans and any funds within the portfolio managed by AllianzGI). The management fee is allocated 65% to the capital and 35% to the revenue accounts respectively, which helps to boost the trust’s level of income, and reflects the board’s expected split of long-term returns between capital and income. MRCH’s FY22 ongoing charge was 0.55%, which was 6bp lower than 0.61% in FY21.

MRCH is a conventional investment trust with one class of share; there are 139.5m ordinary shares in issue and its average daily trading volume over the last 12 months is c 237k shares.