Merchants Trust (The) — Performance shining brightly

Gergel says that in aggregate, the UK stock market is attractively valued. There has been a rotation towards defensive stocks from those of more cyclical businesses due to the risk of earnings estimate downgrades, making cyclical stocks a more fertile hunting ground for new opportunities. The manager suggests that looking forward three to six months, given that some commodity prices have started to roll over, there could be a lower rate of inflation, in which case ‘we may be close to peak inflation/peak concerns about higher interest rates’ he opines. Gergel says that if the economy is slowing, then inflation should decline; hence, ‘we could be past the worst’. In such a scenario, the manager believes that there could be a change in investor sentiment, for the better, at which time ‘cyclicals could come back into vogue’. However, Gergel comments that a return to a 2% inflation rate looks unlikely due to higher wages, exacerbated by a shortage of skilled workers, and supply chain issues, although if demand weakens, these disruptions should be resolved. As a result, in six months, ‘the backdrop could be very different’, suggests the manager. He notes that interestingly, some cyclical shares are hitting three-month relative highs, such as retailer Next and housebuilder Redrow, which could indicate we are at the peak or even past the peak of concerns about the economy. Nevertheless, Gergel is expecting a series of profit warnings. Those companies that are struggling with higher input costs could then start to see lower demand for their goods and services. Whatever the investment backdrop, the manager will continue with his disciplined investment process focusing on undervalued companies with strong fundamentals, aiming to generate a high – and rising – income stream and long-term capital growth for MRCH’s shareholders.

At end-July 2022, MRCH’s top 10 holdings made up 34.6% of the fund, which was a lower concentration compared with 37.1% a year earlier; four positions were common to both periods.

Portfolio activity has stepped up in recent months as market volatility provided Gergel with an increased number of attractive investment opportunities. In March, he initiated a position in Unilever, a large-cap, consumer-staple company, which had not been in MRCH’s portfolio for many years. The firm has suffered from input-cost pressures, and it takes time to pass higher prices on to consumers. Unilever’s growth has lagged that of its peers as COVID-19 has negatively affected its emerging market businesses, which has led to a derating of its shares. Despite this, the company has a strong-brand portfolio and there is a long-term growth opportunity from its emerging market operations (50% of sales). Gergel says that he was able to ‘get a good company at a modest valuation’. Another new holding is OSB Group (OneSavings Bank). MRCH has a position in Barclays, but the manager has been moving the trust’s exposure from the large commodity banks to more specialist operations such as OSB and Close Brothers. These niche businesses are less interest-rate sensitive and generate higher returns. OSB provides buy-to-let mortgages, which is a growing market. It generates high interest rate spreads and its balance sheet is well capitalised. OSB’s shares had derated on macroeconomic concerns, which provided a good buying opportunity. In keeping with Gergel’s disciplined approach, MRCH’s position in RELX was sold as the stock reached fair value.

In April 2022, the manager initiated a position in Atalaya Mining, which owns an ex-Rio Tinto mine in Spain. Gergel likes the outlook for copper as there is high demand for its use in the production of electric vehicles and wind farms, for example. Atalaya Mining has opportunities to expand its production into nearby resources and reduce costs, and operates in a safe jurisdiction, unlike some other copper producers. The manager was able to initiate a position at an advantageous price via a placing, because of a forced seller. Gergel sold MRCH’s small position in ITV as the company is making a large investment in its streaming services ITV Hub and BritBox. This challenged the manager’s original thesis, which was based on the growth in the value of ITV’s content and the free cash flow generation potential of its programming. The company’s capex programme will negatively affect its near-term profits and it will be a long time before the results of this spending can be evaluated. The ITV holding was one of the smaller weightings in MRCH’s portfolio due to the structural risks in its business model. Again, this illustrates the manager’s disciplined investment approach; a change in an investment thesis warrants a review of the company and a position may be sold as a result of the outcome.

There were three new positions added to MRCH’s portfolio in May 2022:

As shown in Exhibit 4 below, MRCH’s performance continues to move in the right direction as the trust is ahead of its blended benchmark over all periods shown in both NAV and share price terms (apart from the last month). The outperformance over the last decade is particularly noteworthy.

Gergel is encouraged by MRCH’s performance, which so far this year has been helped by a takeover bid for HomeServe; the stock had declined on an absence of bad news as growth investors sold their positions. Drax’s share price rose following the Russian invasion of Ukraine and the subsequent spike in energy prices. Its current-year profits are hedged, but higher energy prices should boost subsequent earnings. Drax is benefiting from the realisation that countries need a diverse source of energy supplies. The benefits of the company’s biomass operations have been questioned, but this issue has been trumped by energy availability becoming a priority. Gergel suggests that Drax’s aspirations to be ‘carbon negative’ are really interesting, and given the concerns about climate change, the chances of political approval for its development plans have increased. The company’s share price recently retreated on concerns about an energy tax but has since rallied. The shares of defence company BAE Systems have re-rated, while Man Group has benefited from its ‘trend-following’ and commodity funds, which have performed well.

Detractors to MRCH’s performance this year include not owning AstraZeneca, which has meaningfully outperformed the UK market. Some of MRCH’s cyclical holdings have lagged on concerns about the economy including door and window manufacturer Tyman and housebuilders Bellway and Redrow. Sofa retailer DFS Holdings also has a volatile earnings stream.

The AIC UK Equity Income sector is made up of 22 funds. In Exhibit 6, we show the 17 largest with market caps greater than £100m. Gergel continues to build on MRCH’s successful track record as the trust now holds the number one spot in the selected peer group in terms of NAV total returns over the last one, three and five years (it also ranks first out of the whole UK Equity Income sector over these periods). Over the last 12 months, MRCH has delivered a meaningful 4.7pp higher NAV total return than its second-ranked peer. Over the last decade, the trust ranks fifth, which is 8.6pp higher than the selected peer group average.

At 2 August 2022, MRCH was one of three funds in the selected peer group trading at a premium to NAV. Responding to the strong demand for the trust, the pace of share issuance has stepped up; so far in FY23, the number of shares issued has exceeded that in the whole of FY22. MRCH has a below-average ongoing charge and, in line with its peers, no performance fee is payable. The trust’s level of net gearing is above the peer group mean and it offers the third-highest dividend yield in the selected peer group, 0.7pp higher than average.

As shown in Exhibit 7 below, 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. Distributions are made quarterly in August, November, February/March and May. Gergel reports that MRCH’s income continues to improve; the FY22 dividend of 27.3p per share was 0.94x covered, whereas the FY21 dividend was just 0.68x covered. Since the last financial year end, the income picture looks even brighter. As examples, Barclays has increased its distribution and there have been special dividends from DFS Furniture and Rio Tinto. The manager also highlights IG Group, which issued a positive trading statement and announced its first dividend increase since 2018.

At the end of FY22, MRCH had revenue reserves of 16.0p per share, which is equivalent to 0.59x the last annual dividend. So far in FY23, a first interim dividend of 6.85p per share has been announced, which is 0.7% higher year-on-year. Based on its current share price, the trust offers a 4.8% dividend yield.