The Merchants Trust review

The Merchants Trust (MRCH) seeks attractively valued UK equities. It is one of the oldest investment trusts listed on the London Stock Exchange, and this year marks its 130th anniversary.

 Investment Trust

Events in the year of the trust’s launch in 1889 include the opening of the Eiffel Tower, the launch of the children’s charity NSPCC and the first publication of the Wall Street Journal.

The Merchants Trust aims to provide an above-average level of income and income growth, and long- term capital growth from a relatively concentrated portfolio of ca 40-60 UK equities.

Simon Gergel, chief investment officer for UK equities at AllianzGI, has 31 years of investment experience and has managed the trust since 2006. He works closely with two of AllianzGI’s UK equity specialists, Matthew Tillett (12 years’ experience) and Richard Knight (five years’ experience).

The manager employs a contrarian investment approach, seeking undervalued equities, and primarily invests in high- yielding, well-established UK companies that can be held for the long term.

Since end-January 2017, MRCH has been benchmarked against the broader FTSE All- Share Index rather than the large-cap FTSE 100 Index.

To mitigate risk, the trust must be invested in at least five of the 10 market sectors with each sector limited to 35%, and a single investment may not exceed 15% of assets.

Gearing in a range of 10-25% of NAV, at the time of drawdown, is permitted; at end-March 2019, net gearing was 19.1%. MRCH offers an above-market dividend yield of 5.3% and its annual distribution has increased for the last 37 financial years, with reserves being used to supplement income when required.

Performance

In FY 2019 (ended 31 January 2019), MRCH saw NAV and share price total returns of -5.2% and +1.7%, respectively, compared with the benchmark’s -3.8% total return.

The largest contributor to performance (+1.8pp) over the period was not owning British American Tobacco (BAT), which performed poorly, although the shares have recovered well (+ circa 15% year-to-date) since Gergel bought a position in BAT in January 2019.

Another strong contributor was GlaxoSmithKline (adding 0.8pp), which saw positive developments in each of its three divisions (pharmaceuticals, consumer health and vaccines); while Standard Life Aberdeen was the greatest detractor (-1.2pp), having experienced poor investment performance and client outflows.

MRCH’s NAV and share price total returns are above those of the benchmark over 10 years.

The trust’s share price has also outperformed over three years, over which period MRCH’s discount has narrowed; its shares now regularly trade close to NAV.

The trust suffered a meaningful period of underperformance immediately following the UK’s European referendum, which has negatively affected MRCH’s three-year numbers; the effects of gearing in a falling market in Q4 2018 have also been detrimental.

The Merchants Trust

Price486.0p
Market cap£531m
NAV*476.0p
Discount to NAV2.1%
NAV†487.2p
Discount to NAV0.2%
Yield5.3%
* Excluding income; † including income. As at 7 May 2019.
Source: Edison

Investment strategy – Seeking undervalued UK equities

Manager Simon Gergel believes that stock markets are inefficient, and that thorough fundamental research can uncover mis-priced securities. He has a bias towards higher-yielding stocks, as evidence shows that on average companies paying high dividend yields have delivered above-average total returns, not just higher income streams. The manager always considers the total return potential of each position in the portfolio; a high dividend yield in itself is an insufficient basis for investment, while a holding is not automatically sold if a company’s dividend yield falls below that of the market. Gergel is able to draw on the large resources of AllianzGI, which include a global team of equity and credit analysts; an environmental, social and governance (ESG) team; and the proprietary Grassroots market research platform.

The buy discipline has three pillars, seeking to answer three questions about a company – how good is its business (fundamentals), are its shares undervalued (valuation) and how supportive is the environment (themes)?

  • Fundamentals – focusing on industry dynamics, a company’s competitive position, its financials, including growth rates, cash flow and balance sheet strength and its ESG track record.
  • Valuation – in absolute and relative terms versus history, the sector and the market, along with dividend yield.
  • Themes – analysis of the macroeconomic outlook, the business cycle and industry/secular themes. The manager aims to avoid value traps such as stocks that look cheap, but are structurally challenged.

MRCH’s resulting portfolio typically contains 40-60 positions. Holdings may be sold if the target price is met, there is a change in the investment case, or a superior investment opportunity has been identified. Gergel highlights that each of the holdings can be categorised in one of four ways:

  • High yield (35.0% of the portfolio at end-FY 2019) – undervalued companies with a high dividend yield. Expected return is from dividends and revaluation.
  • Cyclical growth (35.6%) – companies that can grow over a cycle, but may have economic or market sensitivity. Expected return is from revaluation, compounding growth and dividends.
  • Defensive growth (20.9%) – firms that can grow over time with limited economic sensitivity. Expected return is from dividends, compounding growth and potentially revaluation.
  • Special situations (8.5%) – companies undergoing a turnaround or restructuring. Expected return is primarily via capital appreciation as their shares are revalued.

ESG is an increasingly important element of the research process; in FY 2019, Gergel and his team engaged 44 times with 24 different companies (around half of the portfolio), covering a variety of topics including environmental issues, remuneration, board structure, corporate strategy, and mergers and acquisitions.

The manager’s view – Polarisation providing opportunities

Commenting on the macro backdrop in the UK, manager Simon Gergel said it is still dominated by Brexit uncertainty, although he believes the chance of a ‘no-deal’ exit is looking more remote.

The manager suggested that the lower expectation of a worst-case scenario means investors are more optimistic about the outlook for the UK stock market, albeit that concerns remain at both the corporate and consumer level.

Companies are reluctant to make investment decisions, and Gergel said “life is still getting a bit tougher” for industrial companies, although the UK economy has experienced a boost from inventory stocking. The manager is confident that when there is more clarity regarding Brexit, pent-up demand should be an important driver for the UK economy.

Looking at global growth, Gergel believes that the trade relationship between the US and China is looking more positive. Both parties would benefit from a resolution to the recent dispute, and China is also stimulating its economy, although the outlook for European growth remains muted.

Overall, he said that the world economy is slowing, but the environment is “not terrible”, and has been helped by the US Federal Reserve adopting a more dovish stance by putting interest hikes on hold.

The manager is keen to emphasise that the majority of profits generated by UK companies come from overseas, so he is not overly concerned that the UK economy is “muddling along”, helped by low levels of unemployment.

Gergel suggested that since the global financial crisis, there has not been too much to worry about in the global macro environment, as any moderations in economic growth have so far not been significant, nor have they been sustained.

In terms of the structure of the UK stock market, the manager noted wide valuation dispersions within, not just between, different sectors.

He argued that this environment is providing interesting investment opportunities for value investors who have a long-term view. Gergel noted the underperformance of smaller-cap equities; as asset managers have experienced outflows, this has put pressure on the share prices of widely owned smaller companies, which he said “has created some real bargains”. As an example, he has added to MRCH’s holding in specialist geotechnical contractor Keller following share price weakness.

The manager pointed out that value stocks have underperformed growth names over the last 10 years, as the low level of interest rates as a result of quantitative easing has supported ‘bond proxies’. He believes that over time, as interest rates normalise, value stocks should perform relatively better.

During recent years, when the US was raising interest rates, Gergel noted that value stocks did not outperform; however, over the long term, they have generated higher total returns than growth stocks.

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