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Meaningful improvement in relative performance

The Merchants Trust 18 March 2021 Review
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The Merchants Trust

Meaningful improvement in relative performance

Investment trusts
UK equity income

18 March 2021

Price

495.0p

Market cap

£600m

AUM

£692m

NAV*

491.3p

Premium to NAV

0.8%

NAV**

494.8p

Premium to NAV

0.0%

*Excluding income. **Including income. As at 16 March 2021.

Yield

5.5%

Shares in issue

121.1m

Code

MRCH

Primary exchange

LSE

AIC sector

UK Equity Income

52-week high/low

496.0p

302.5p

494.8p

288.6p

*Including income.

Gearing

Net gearing*

16.9%

*As at 31 January 2021.

Fund objective

The Merchants Trust’s investment objective is to provide an above-average level of income and income growth, together with long-term growth of capital, through investing mainly in higher-yielding large-cap UK companies. With effect from 1 February 2017, the benchmark is a broad UK stock market index (previously an index of the 100 largest UK companies).

Bull points

Attractive dividend yield and high level of revenue reserves.

Long-term record of outperformance.

Competitive fee structure.

Bear points

Relative performance is likely to struggle in a growth/momentum-led market.

FY21 dividend is likely to be uncovered, but income outlook is improving.

UK economy could struggle under government’s heavy debt load.

Analysts

Mel Jenner

+44 (0)20 3077 5720

Sarah Godfrey

+44 (0)20 3681 2519

The Merchants Trust is a research client of Edison Investment Research Limited

The Merchants Trust (MRCH) is managed by Simon Gergel at Allianz Global Investors. He suggests the company is ‘in a much better place’ compared with early 2020. The manager now has more confidence in the trust’s income prospects as dividends are resuming and in some cases being raised, and he has been able to take advantage of stock market volatility to reposition the portfolio. Gergel believes MRCH’s shareholders appreciate how the trust’s investment process remains consistent despite periods of market volatility, while the board’s progressive dividend policy provides an attractive income stream in excess of the UK market. This is reflected in MRCH’s relative performance, which has improved considerably in recent months. The trust currently offers a 5.5% dividend yield, the second highest of the 17 larger-cap peers in the AIC UK Equity Income sector.

MRCH offers an attractive above-market dividend yield

Source: MRCH, Edison Investment Research

Why consider MRCH now?

The UK economy is recovering from the negative effects of the global COVID-19 pandemic and there is likely to be significant pent-up demand once lockdowns end. Brexit has been an overhang to the valuation of the UK market since mid-2016, offering the potential for a rerating as business conditions improve.

The analyst’s view

MRCH offers shareholders a diversified portfolio of attractively valued UK shares across the market-cap spectrum and an above-market dividend yield. There has been a significant uplift in the trust’s relative performance now the stock market leadership has started to broaden out, although there is still a wide divergence between the valuation of growth and more cyclical businesses. MRCH’s NAV has now outperformed the broad UK market over the last one, three, five and 10 years.

The trust is in an improved position regarding income than it was six to nine months ago as exposure to higher-yielding companies has increased, more firms are considering paying a dividend now their balance sheets have been repaired, and the manager expects a significant income recovery in FY22 (ending 31 January 2022). At the end of FY20, the trust had more than one year’s annual dividend in revenue reserves, which is available to sustain MRCH’s 38-year record of consecutive annual dividend increases.

The manager’s view: Opportunities for UK investors

Manager Gergel says it is ‘an interesting time to be investing in the UK and I am quite excited about what I see in the market’ as the economy is improving and dividends are returning rapidly as businesses recover. In terms of valuation, the UK remains at a multi-decade extreme discount compared with Europe, having been devalued since mid-2016 due to the Brexit overhang, although this risk has now receded. The manager explains the UK is more oriented towards cyclical businesses, with large exposures to the banking, mining and energy sectors. There is potential for higher levels of merger and acquisition activity given low valuations and interest rates, and appetite from both corporate and private equity buyers, which could be supportive for the equity market. Recent bids include for Aggreko, RSA (which was in MRCH’s portfolio) and Signature Aviation.

In the last few quarters, there has been significant polarisation in the market between the performance of growth and value stocks and, while the gap has started to close, there is still a large divergence between the valuation of growth and value stocks. Gergel highlights the relative value within MRCH’s portfolio, which has an average forward P/E multiple of 11.4x and is a c 30% discount to the broad UK market. The fund has little exposure to highly priced segments of the market (c 2% of the portfolio is valued above 20x compared with c 20% of the UK market).

While the manager is constructive on the outlook for the UK, he is also mindful of the risks. If the economy recovers, there is an overhang from the very high government debt levels, ‘these borrowings have to be paid for’. Gergel suggests the outlook for inflation is ‘an interesting discussion’ and, given pent-up demand, he expects higher bond yields and interest rates over time. ‘Activity could be choked off by these, although it is encouraging that the economy is now strengthening’, he adds.

The manager comments he is ‘not buying low-quality companies, we are able to buy decent businesses at attractive valuations’. While stocks are all selected on a bottom-up basis, there are a number of themes represented within the portfolio; three of which are discussed below.

Home economics: strong fundamentals in housing and renovation, maintenance & improvement. Gergel says many people have been able to save money during the pandemic, by not spending on holidays, commuting or eating out. There has been a strong recovery in the housebuilding sector and companies such as DFS (sofas) and Tyman (door and window components) have delivered robust trading results, which are now exceeding pre-pandemic levels. Spending on the home has generally been soft for a number of years, as house-move volumes have been low; but there is now pent-up demand and activity is expected to pick up.

Digital winners: on the right side of structural change. IG Group is a market leader in financial trading, targeting experienced individuals, the manager explains that its volumes have been strong helped by stock market volatility and people are generally taking more of an interest in their personal affairs. The company has a modest valuation coupled with a high return on equity as there are concerns about regulatory risk and moderating growth as stock market volatility returns to more normal levels (IG Group’s 2022 consensus earnings expectations are below those for 2021). However, the manager says the company has a huge client base and has been expanding into new product areas and territories such as Asia; he believes the market does not appreciate the company’s sustainable growth prospects. Entain (formerly GVC Holdings, sports betting and gambling) is benefiting from growth in online betting and deregulation in the US, which is allowing more states to participate in these activities. The company is now the third largest online operator in the US via its JV with MGM Resorts International. Gergel comments there are ‘ways to invest in digital winners, while avoiding the expensive stocks in the market’.

Improving business mix: underappreciated transformation. Tate & Lyle refines corn into high-fructose corn syrup, which is used in fizzy drinks. This is a commodity business, but the company also has speciality operations where fats and sugars can be replaced by more healthy natural products. Tate & Lyle’s current business mix is c 50:50 between commodity and speciality operations. As the percentage of speciality revenues rises, helped by acquisitions, the valuation of Tate & Lyle should improve as pure-play competitors such as Switzerland-based Givaudan and US-based International Flavors & Fragrances trade on higher multiples.

Portfolio construction and activity

Exhibit 1: Portfolio sector exposure vs benchmark (% unless stated)

Portfolio end-
January 2021

Portfolio end-
January 2020

Change
(pp)

Index
weight

Active weight
vs index (pp)

Trust weight/
index weight (x)

Consumer goods

23.1

15.8

7.3

16.8

6.3

1.4

Financials

20.5

25.5

(5.0)

25.5

(5.0)

0.8

Industrials

18.3

20.9

(2.6)

12.7

5.6

1.4

Oil & gas

8.7

7.7

1.0

7.5

1.2

1.2

Utilities

7.3

8.2

(0.9)

3.1

4.3

2.4

Consumer services

6.4

11.7

(5.3)

12.5

(6.1)

0.5

Healthcare

5.8

5.7

0.1

9.3

(3.5)

0.6

Telecommunications

4.4

0.0

4.4

2.2

2.2

2.0

Basic materials

2.9

4.0

(1.1)

9.3

(6.4)

0.3

Technology

1.1

0.0

1.1

1.1

(0.0)

1.0

Cash

1.5

0.5

1.0

0.0

1.5

N/A

100.0

100.0

100.0

Source: The Merchants Trust, Edison Investment Research. Note: Numbers subject to rounding.

MRCH’s sector exposure is shown in Exhibit 1. Over the 12 months to the end of January 2021, the largest changes were a higher weighting to consumer goods (+7.3pp) and lower weightings to consumer services (-5.3pp) and financials (-5.0pp). While all stocks are selected on a bottom-up basis, compared with the index, the trust favours consumer goods (+6.3pp), industrials (+5.6pp) and utilities (+4.3pp). The largest underweight positions were basic materials (-6.4pp), consumer services (-6.1pp) and financials (-5.0pp).

Gergel explains that in 2020 there were broadly three phases of portfolio activity. Going into the year, MRCH’s portfolio had a relatively high level of cyclical exposure so he increased the fund’s weighting in more defensive businesses and companies with dependable income, including Vodafone. He sold positions in businesses he considered fully valued such as Prudential and Sirius Real Estate. The second phase was to take advantage of market volatility, by buying high-quality companies on reasonable valuations, such as Next and Close Brothers, which was funded by the sale of NatWest. Pennon was also sold as it became fully valued. As the market rallied towards the end of the year, lower-conviction cyclical positions that had recovered strongly were sold including National Express and Senior. A number of positions were added to including Entain, IG Group, National Grid and Meggitt (where the manager expects dividend payments to resume).

In December 2020, Gergel participated in the initial public offering of Conduit Holdings, a new reinsurance company, established in Bermuda and listed in the UK, which has been set up to take advantage of a cyclical upturn in insurance pricing. This follows three years of large losses in the insurance industry, which has led to capacity constraints among insurers and sharply rising insurance rates. Conduit offers a mid-single-digit dividend yield. In February 2021, the manager initiated a position in DCC, a distribution business with a strong record of growth through consolidating fragmented markets, initially in Ireland and the UK, which now operates in the rest of Europe and the US. DCC has grown its dividend for 26 years, with 9% compound annual growth over the last decade. The company’s businesses span four areas: healthcare, technology, liquefied petroleum gas, and fuel and oil. Its shares historically traded on a high valuation, but de-rated in recent months, on concerns about the long-term prospects for its energy businesses, which Gergel believes are unfounded, and as the market rotated towards more cyclical companies trading on lower multiples.

Performance: MRCH has made up 2020’s lost ground

Exhibit 2: Five-year discrete performance data

12 months ending

Share price
(%)

NAV*
(%)

Blended benchmark **(%)

CBOE UK All companies (%)

CBOE UK 100 Companies (%)

28/02/17

23.1

19.1

24.3

22.8

24.1

28/02/18

5.5

6.5

4.4

4.4

3.4

28/02/19

6.7

1.4

1.7

1.7

2.1

29/02/20

4.3

1.6

(1.4)

(1.4)

(2.7)

28/02/21

2.1

5.1

2.8

2.8

6.9

Source: Refinitiv. Note: All % on a total return basis in pounds sterling. *NAV with debt at market value. **Blended benchmark is UK 100 Index until 31 January 2017 and UK All-Share Index thereafter.

Exhibit 3: Investment trust performance to 28 February 2020

Price, NAV and benchmark total return performance, one-year rebased

Price, NAV and benchmark total return performance (%)

Source: Refinitiv, Edison Investment Research. Note: Three, five and 10-year performance figures annualised.

Exhibit 4: NAV total return performance relative to the benchmark over three years

Source: Refinitiv, Edison Investment Research

MRCH’s relative returns are shown below in Exhibit 5. The sharp improvement in relative NAV total return performance over the last six months means the trust’s NAV is ahead of its blended benchmark over all periods show, Gergel comments that ‘performance in recent months is pleasing following on from the majority of 2020, where there was a lot of pressure on the value style’. He took advantage of opportunities arising as a result of stock market volatility and ‘the results have come through really well’. The manager says that all of the NAV and share price underperformance in early 2020 has be recouped and, while the last five years have been difficult for value investors, ‘MRCH has delivered a decent set of numbers’. He says the improvement in relative performance in recent months is evidence of the fund’s significant value bias. Gergel does not believe that opportunities within the UK market have been exhausted, as there are still many companies that are highly valued; he suggests they could come under pressure due to profit taking, which could result in attractive entry points for new investments.

Exhibit 5: Share price and NAV total return performance, relative to indices (%)

 

One month

Three months

Six months

One year

Three years

Five years

10 years

Price relative to blended benchmark

2.0

4.4

18.1

(0.6)

10.3

10.5

17.9

NAV relative to blended benchmark

2.2

6.6

15.6

2.3

5.1

2.7

15.9

Price relative to CBOE UK All Companies

2.0

4.4

18.1

(0.6)

10.3

11.8

13.6

NAV relative to CBOE UK All Companies

2.2

6.6

15.6

2.3

5.1

3.9

11.7

Price relative to CBOE UK 100

2.6

5.8

20.4

(4.5)

6.9

8.2

15.5

NAV relative to CBOE UK 100

2.8

8.0

17.9

(1.7)

1.8

0.6

13.5

Source: Refinitiv, Edison Investment Research. Note: Data to end-February 2021. Geometric calculation.

Peer group comparison

MRCH is a member of the AIC UK Equity Income. In Exhibit 6, we show the 17 of the 23 funds that have market caps above £100m. MRCH’s NAV total return is above the selected group average over one, three and five years, ranking second, sixth and seventh respectively, while its total return is below average over the last decade, ranking 11th. The trust’s NAV total returns rank favourably versus other value strategy funds such as Edinburgh Investment and Temple Bar over the last three and five years, both of which have changed their managers. Due to high levels of investor demand, MRCH regularly trades at a premium and has been issuing shares. On 17 March, the trust was trading at a 0.5% premium compared with an average valuation of the selected peer group of a 2.6% discount. MRCH has the third-highest level of gearing and an attractive dividend yield, ranking second and 1.4pp above the mean of the selected peer group.

Exhibit 6: Selected peer group as at 17 March 2021*

% unless stated

Market
cap £m

NAV TR
1 year

NAV TR
3 year

NAV TR
5 year

NAV TR
10 year

Discount
(cum-fair)

Ongoing charge

Perf.
fee

Net gearing

Dividend yield

Merchants Trust

600.1

64.4

17.6

46.9

117.6

0.5

0.6

No

117

5.5

Aberdeen Standard Equity Inc Trust

162.4

45.5

(9.8)

5.0

86.1

(5.5)

0.9

No

111

6.2

BMO Capital & Income

321.1

46.6

12.0

49.0

121.0

(2.8)

0.6

No

105

3.9

BMO UK High Income Units

115.7

48.6

11.5

33.0

95.8

(9.0)

1.0

No

108

4.3

City of London

1,623.6

35.6

6.5

24.4

114.4

3.0

0.4

No

108

5.1

Diverse Income Trust

393.8

57.1

23.3

47.7

(1.3)

1.1

No

100

3.3

Dunedin Income Growth

438.6

47.1

28.3

59.2

124.4

(2.3)

0.6

No

109

4.3

Edinburgh Investment

1,005.5

52.1

3.5

12.2

126.2

(7.8)

0.6

No

106

4.1

Finsbury Growth & Income

1,927.8

30.0

23.4

60.5

253.6

(0.4)

0.6

No

101

1.9

Invesco Income Growth

160.5

35.6

10.0

23.9

119.5

(6.7)

0.7

No

107

4.3

JPMorgan Claverhouse

384.5

50.7

11.8

44.3

119.1

(4.5)

0.7

No

118

4.5

Law Debenture Corporation

875.6

58.0

25.8

69.3

176.5

2.8

0.6

No

112

3.8

Lowland

337.7

48.0

(2.6)

26.5

127.6

(5.8)

0.6

No

118

4.8

Murray Income Trust

985.5

39.0

22.4

50.9

121.6

(3.3)

0.6

No

111

4.1

Schroder Income Growth

202.3

52.5

11.3

35.2

126.5

0.1

0.9

No

106

4.3

Temple Bar

778.4

65.5

3.1

27.5

95.1

(0.8)

0.5

No

113

3.3

Troy Income & Growth

242.1

19.6

9.5

21.7

112.2

(0.5)

0.9

No

100

2.7

Selected group average (17 funds)

620.9

46.8

12.2

37.5

127.3

(2.6)

0.7

109

4.1

MRCH rank

7

2

6

7

11

3

11

3

2

Source: Morningstar, Edison Investment Research. Note: *Performance to 16 March 2021. NAV with debt at par. TR, total return. Net gearing is total assets less cash and equivalents as a percentage of net assets.

General disclaimer and copyright

This report has been commissioned by The Merchants Trust and prepared and issued by Edison, in consideration of a fee payable by The Merchants Trust. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2021 Edison Investment Research Limited (Edison).

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Level 4, Office 1205

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NSW 2000, Australia

General disclaimer and copyright

This report has been commissioned by The Merchants Trust and prepared and issued by Edison, in consideration of a fee payable by The Merchants Trust. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2021 Edison Investment Research Limited (Edison).

Australia

Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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