The Merchants Trust — Finding high-quality, well priced opportunities

Gergel highlights the importance of dividends, which have provided the bulk of total returns in the UK market over the last 20 years. He explains that while the investment backdrop is now quieter, at the end of 2020 there was a big rotation from higher-growth/quality stocks into value names due to increased confidence about an economic recovery following positive COVID-19 vaccine trails. The more intense investor focus on valuation has been beneficial for MRCH’s relative performance; sectors that have performed well in recent months include banks and housebuilders, both of which are represented in the trust’s portfolio.

The manager notes that, in aggregate, UK stocks are inexpensive compared with other major markets, with the UK market at a 40-year extreme discount versus European stocks despite receding Brexit risks. Hence, he considers there is a big opportunity in selected UK shares. Gergel explains that the UK market remains polarised, with value shares trading at a significant discount to growth stocks, meaning he is still able to buy good companies at a discount to their intrinsic value despite their share prices rallying in recent months. The manager says that there are a significant number of UK companies trading on high or low forward P/E multiples ‘with not much in the middle’. MRCH’s portfolio is skewed towards stocks trading on lower valuations (in aggregate, around a 20% discount versus the benchmark).

Gergel can now invest up to 10% of MRCH’s portfolio in overseas equities. The trust was originally launched as an international fund, but over the last 20 years or so has solely invested in UK equities (although it should be noted that the majority of UK companies’ sales and profits are generated overseas). The manager explains that during the pandemic the opportunity set to invest in higher-yielding UK companies declined as a number of firms cut their dividends. With a more concentrated UK market the board considered it prudent to allow investment in overseas equities, opening up more opportunities to diversify the portfolio and MRCH’s income stream.

Recent company meetings have involved discussions about inflationary pressures stemming from material shortages and logistics problems such as a lack of available shipping containers. Gergel says that there are initial signs of wage inflation, and it is an important issue for him to determine which firms will be able to pass on higher costs; he comments that so far, higher prices have been neutral or beneficial, rather than a problem, for portfolio companies.

The manager highlights some of the themes represented in MRCH’s portfolio: environmental change enablers, undervalued growth and uncorrelated value.

MRCH’s sector exposure is shown in Exhibit 1, it is not possible to compare the weightings year-on-year due to a recent change in index classifications. Gergel’s active approach is illustrated by the trust’s largest divergencies to its benchmark with overweight exposures to utilities (+5.4pp) and industrials (+5.0pp), with below-index weightings in basic materials (-7.2pp) and financials (-3.5pp).

There have been quite a lot of changes within the portfolio since our last published note in March 2021, and the manager has taken the opportunity to lock in profits in some of MRCH’s cyclical holdings that have performed well. He sold the positions in BT and CRH as their shares had re-rated, and also Hammerson once its share price recovered, along with the small remaining holding in Standard Life Aberdeen (now known as abrdn), whose operational turnaround has proved to be problematic.

There is a lack of UK reinsurance companies in which to invest, so Gergel has initiated positions in France-listed SCOR and Swiss Re. He says that the reinsurance pricing cycle is favourable –natural catastrophes in recent years have led to significant industry losses, which in turn leads to firmer pricing. The manager says that SCOR and Swiss Re are modestly valued and offer attractive dividend yields. France-listed pharma company Sanofi was added to the portfolio; it is not dissimilar to GlaxoSmithKline as it also has a large consumer unit. The manager believes that the company has good growth prospects such as monoclonal antibody Dupixent for the treatment of allergic diseases including eczema and asthma, but is trading at an attractive valuation. He says that Sanofi is being managed more aggressively; as an example, the number of stock keeping units in the consumer division has been reduced in order to focus on the company’s stronger brands. Another new position is France-listed TotalEnergies which, like BP and Royal Dutch Shell, is transitioning its business into renewable energy. However, unlike its peers, TotalEnergies has maintained the level of its dividends. Gergel is optimistic about the company’s high cash flow generation and prospects for the oil & gas sector, which he considers to be undervalued and out of favour with investors despite a rising oil price.

There is a new holding in RELX. The manager says that this position provides exposure to strong businesses with good growth potential at a sensible price. The company is a global provider of information and data services to the STEM, risk and legal sectors plus it has an exhibition business. Over the last 20 years, RELX has been transitioning its operations from print to digital distribution, which is accelerating its growth rate. It is the number one global scientific publisher (including The Lancet medical journal) and the second largest legal publisher with a significant operation in the US. The company’s risk businesses are growing rapidly in areas such as insurance and cyber information. RELX’s exhibition division has been hit hard by the global pandemic, but the manager expects this business to recover despite underlying industry changes. The company has a c 5% free cash flow yield and at the time of purchase offered a 3% dividend yield.

In June 2021, Gergel initiated two new positions in leading UK supermarket Tesco and Drax. Food retailers have experienced strong business trends during the pandemic and have responded well to the competitive threats from low price operators Aldi and Lidl, which lack significant online operations. Tesco on the other hand has ramped up its delivery service and is also the UK’s largest wholesaler following its 2018 acquisition of Booker. The company’s catering and banking businesses are improving, and Tesco has sold its Asian and Polish divisions to refocus on its UK, Irish and other Eastern European operations. Tesco has modest capex requirements and is generating high levels of free cash flow. Its shares have derated, despite the company’s market leadership position, and are trading on a c 13x forward P/E multiple, and the firm has a c 9% free cash flow yield. There has been increased investor interest in the food retailing sector recently following bids for competitor Morrisons.

Drax operated the UK’s biggest coal-fired power station, but it was retrofitted to use biomass wood chips and pellets; earlier this year the company acquired Canada-based wood pellet producer Pinnacle Renewable Energy. Drax also has hydroelectric assets, so there is more than one strand to its business. It has very low carbon emissions as carbon is absorbed by its growing forests. Most of the timber produced in North America is used in the construction industry, while sawdust and unused small pieces of wood are used for biomass. The company is generating significant cash flow and profits due to attractively priced contracts extending out to 2027. Investors question what happens after Drax’s long-term contracts expire; however, Gergel believes that the company’s downside risk is limited if they are not renewed given its hydroelectric assets, wood pellets business and a power system stability contract with National Grid. He also considers that Drax has significant upside potential due to its bioenergy carbon capture and storage system. CO2 is pumped into the ground (into old oil wells) and the business is carbon negative; these types of projects will be necessary for the UK to reach its 2050 carbon-neutral targets. Drax’s operation will require subsidies from the UK government, which considers carbon neutrality one its high-profile objectives. The company provides one of the few ways that this can be achieved in scale. News about government subsidies is likely in the next 12–18 months, which the manager suggests could transform the economics of Drax’s business. As one of the few carbon-negative plays in the UK stock market, he believes the company could attract significant investor interest.

MRCH’s relative return record has progressed nicely, and the trust is ahead of its benchmark in both NAV and share price terms over almost all of the periods shown in Exhibit 4. Gergel explains that economic recovery and higher investor confidence have been beneficial for the trust’s performance over the last six months. Positive contributors this year include Tyman, Barclays, SThree, WPP, Man Group, St James’s Place and DFS; these are cyclical businesses that are benefiting from a stronger economy. Companies that have detracted from MRCH’s relative performance include not holding positions in Lloyds, Glencore and Anglo American. The manager is encouraged that there have not been any ‘blow-ups’ in the portfolio so far in 2021.

There are 22 funds in the AIC UK Equity Income sector. In Exhibit 6, we show the 17 largest that have market caps above £100m. MRCH’s NAV total return is above the selected group average over one, three and five years, ranking first, seventh and seventh respectively, while trailing over the last decade, ranking 12th. The trust’s NAV total returns rank favourably versus other value strategy funds such as Edinburgh Investment and Temple Bar. Due to strong investor demand, MRCH now often trades at a small premium, unlike the majority of its peers, and there has been active share issuance, thereby spreading costs over a larger base and increasing liquidity. The trust has a competitive ongoing charge, and no performance fee is payable; its level of gearing is above the mean. Gergel explains that some of MRCH’s peers have either maintained or cut their dividends (Temple Bar and Troy Income & Growth), whereas the trust has a growing distribution, and the board has stressed its commitment to this strategy. Based on its current share price, MRCH offers a 5.3% dividend yield, which is the second highest in the selected peer group (1.4pp above average).