The Merchants Trust — Benefits from announced debt refinancing

On 23 October 2017, MRCH announced that it had priced a £35m fixed rate, 35-year secured private placement note at an interest rate of 2.96%. The effective funding date is expected to be 18 December, with semi-annual interest payments due on 18 December and 18 June. The new note will rank pari passu with MRCH’s other secured debt and will be used to repay £34m of high-cost (11.125%) borrowings maturing in early January 2018.

As shown in Exhibit 2, the debt refinancing brings down MRCH’s average cost of debt and locks in long-term refinancing. Gergel says that the ability to borrow at c 3% and invest in the UK stock market, which is yielding c 4%, is a good long-term proposition for shareholders, as they will be better off even if there is no capital or dividend growth. Interest is charged 65% to the capital account and 35% to the revenue account, so the lower interest rate will save £1.8m and £1.0m in annual interest payments to the respective accounts. The manager says that extending the life of MRCH’s debt profile from seven to 15 years is important, as it ensures the manager is able to invest with a long-term view, as befits an investment trust that is nearly 130 years old.

MRCH was launched in February 1889, making it one of the oldest investment trusts listed on the London Stock Exchange. It is managed by AllianzGI, which has assets under management approaching €500bn. MRCH aims to generate an above-average level of income and income growth, along with long-term capital growth, from a relatively concentrated portfolio (c 40 to 60 holdings) of UK equities. Since 2006, the lead manager has been Simon Gergel, AllianzGI’s chief investment officer for UK equities.

MRCH was historically benchmarked against the FTSE 100 Index, but since end-January 2017 the benchmark is the FTSE All-Share Index, reflecting an evolution towards less large-cap exposure. The portfolio must be invested across at least five sectors, with a maximum 35% in any single sector, and no single position may exceed 15%. At the time of drawdown, gearing of 10-25% of net assets is permitted. MRCH has a distinguished dividend history and its yield compares favourably with the average of its peers. The annual payment has increased for the last 35 consecutive years, using reserves when necessary to maintain the dividend record.

Gergel says that while Brexit is a risk to the domestic economy, a lot of UK companies are exposed to relatively stronger global markets, and so far UK economic data are coming through better than would have been expected following the referendum. The manager says the UK stock market is making steady progress. He notes that overall volatility has been low, although some individual stock prices have been very volatile, which has provided opportunities for those investors able to take advantage of pricing anomalies. Gergel suggests that many UK consumer cyclical companies are under pressure; he is considering whether a number of retail and leisure companies may be attractive opportunities given their relatively low valuations. However, he will only invest if he is confident in a company’s fundamental outlook, such as Greene King, where he has added to the position following a period of share price weakness due to a profits warning.

Gergel says that in aggregate investors are becoming more optimistic on the global economy, so have started to buy more cyclical stocks. He notes that if interest rates rise on the back of higher inflation, it will be positive for banks and financials, while having a detrimental impact on ‘bond proxies’, such as consumer staples, where he is underweight, as he considers that within the sector, company valuations are generally unattractive.

The manager is able to draw on the broad resources of AllianzGI, which, along with fundamental equity research, focuses on macroeconomics; environmental, social and governance research; credit analysis and the proprietary GrassrootsSM market research product. When considering a potential purchase, Gergel considers three elements: fundamentals, valuation and themes. Fundamental analysis includes an assessment of industry dynamics, a company’s competitive position, its financials and corporate governance track record. The manager considers valuations on both an absolute and relative basis, while themes takes into account the macro environment, stage of the business cycle and secular trends. A stock may be sold if it has achieved its target price, if there is a change in the investment case or if a better investment opportunity is available.

Style analysis data from AllianzGI highlights the nature of MRCH’s relatively concentrated current portfolio. It ranks highly on value metrics, such as dividend, earnings and cash flow yields, but is also not anti-growth, as the portfolio has tilts towards earnings and sales growth. For an actively managed portfolio, MRCH has a relatively low active share of 64%. Active share is a measure of how a portfolio deviates from a benchmark, with 100% reflecting no commonality and 0% full index replication. Gergel explains the low number is due to his positions in index heavyweights BP, Royal Dutch Shell, GlaxoSmithKline and HSBC, which he believes all offer good value.

As shown in Exhibit 1, over the last 12 months there has been little change in portfolio concentration. At end-October 2017, the top 10 positions comprised 44.0% versus 47.1% at end-October 2016. Over 12 months to end-September 2017 there have been modest changes on a market cap basis, with 3.1pp higher exposure to mid-cap FTSE 250 companies and 2.0pp lower exposure to large-cap FTSE 100 companies (Exhibit 3).

On a sector breakdown, over the last 12 months, the largest increases in exposure are industrials (+2.7pp) and financials (+2.3pp), with the largest decrease in consumer services (-2.2pp). The structure of the portfolio is broadly similar to our last report published in June 2017, with overweight positions in industrials and utilities and a large underweight exposure in consumer goods stocks, unlike many of MRCH’s peers, as the manager considers their valuations unattractive.

There are two recent new holdings in MRCH’s portfolio: Bovis Homes and WPP. The manager says that fundamentally, Bovis is a standard house builder of c 3,500 homes per annum, primarily in the south of England, outside of London. The company has a good land bank of more than four years and has net cash on the balance sheet. Bovis got into trouble in 2015/16 as the company tried to grow too quickly. It did not have enough skilled employees, which led to problems of missed sales and product quality, resulting in two major profit warnings. In June 2017, the shares were trading at just above book value, which Gergel considered an attractive entry point. There is a new management team in place and the new CEO has delivered a clear strategy to focus on high-quality delivery and lower costs. The manager believes that in recovery situations such as Bovis, there is often the potential for much higher cost reductions than originally envisaged. So far this year, Bovis has fought off two takeover bids from companies attracted to the value of its land bank.

The manager says that the holding in WPP is contentious, as the advertising industry has had a tough H117, due to consumer companies cutting back advertising spending. This has led to questions about a structural change in the industry and how well WPP is positioned for the future. Gergel takes comfort from the fact that following a series of acquisitions, more than 40% of the company’s business is digital and 30% of revenues are from higher-growth emerging market regions. He believes WPP’s business model is not broken, that its recent business weakness is cyclical rather than structural, and that its stock price can re-rate as investor confidence improves. Unusually, WPP now has a higher dividend yield than the UK stock market, and is trading on a low double-digit earnings multiple, rather than its typical mid-to-high teens level.

In absolute terms over the last 12 months, MRCH has outperformed the benchmark. Its NAV and share price total returns of 15.5% and 21.5%, respectively, compare to the benchmark’s 13.2% total return (Exhibit 5, RHS). Performance has been helped by periods of value rather than growth leadership in the stock market and by not holding some big underperforming stocks, such as Provident Financial. The largest contributors to the positive returns include administration and payment services provider Equiniti, and global investment company Standard Life Aberdeen. Equiniti has benefited from Capita’s sale of its share registration business for a full price, which has led to a positive read-through for the value of Equiniti’s similar operations. In addition, Equiniti’s acquisition of Wells Fargo’s US share registry brings opportunities to reduce costs and increase cross-selling opportunities. Gergel says that there is now more excitement about the Standard Life/Aberdeen merger, suggesting that there are huge opportunities for cost cutting. He notes that the limited business overlap means there are less concerns about asset outflows, and Aberdeen’s focus on emerging markets is positive, as investor sentiment towards the regions is improving.

MRCH’s relative returns are shown in Exhibit 6. Its improving near-term performance means that the trust is now ahead of the blended benchmark over one, five and 10 years in both NAV and share price terms.

MRCH’s current 5.3% share price discount to cum-income NAV with debt at market value is modestly wider than the averages of the last one, three, five and 10 years (range of 2.3% to 5.7%). There is scope for the discount to narrow following the recent announcement regarding the restructuring of a large tranche of MRCH’s high-cost debt, or if the manager is able to build on the trust’s near-term improving investment performance.

The market value of MRCH’s debt is higher than its par value due to the current low level of interest rates, which means that the value of the NAV with debt at par value is higher than the value of the NAV with debt at market value. As a result, the share price discount to NAV with debt at market value is lower than the discount to NAV with debt at par value.

MRCH is a conventional investment trust with one class of share; there are currently 108.7m ordinary shares in issue. Following the debt restructuring highlighted on page 3, MRCH will have the following pro forma £112m debt profile: a c £45m 9.25% bond maturing in 2023, a c £30m 5.875% bond maturing in 2029, a £35m 2.96% note maturing in 2052, a £1.4m 4% perpetual debenture stock and £1.2m 3.65% cumulative preference shares. In FY17, the annual management fee was 0.35%; it is charged 65% to the capital account and 35% to the revenue account, reflecting the board’s expected split of capital and income returns. The ongoing charge in FY17 was 0.63%; while 5bp higher than in FY16, the charge remains competitive with the average of MRCH’s peers shown in Exhibit 11.

MRCH pays quarterly dividends in August, November, February and May. The trust aims to generate a high and growing level of income, and annual dividends have increased in each of the last 35 years. In FY17, the annual dividend of 24.2p was 0.8% higher than FY16 and was broadly covered by revenue. At end-H118, revenue reserves were £27.9m, which was more than 1x the last four quarterly dividend payments. MRCH’s current dividend yield is 5.0%.

MRCH’s attractive distribution policy is illustrated in Exhibit 10. The left-hand chart shows that over the last 20 years, MRCH’s dividend yield has remained higher than the dividend yield of large-cap UK equities. The right-hand chart compares MRCH’s annual dividend growth with the rate of UK inflation. Over the last 35 years of consistent growth, MRCH’s dividends have compounded at an annual rate of 7.2%, which is considerably higher than the rate of UK inflation.

MRCH is a member of the AIC UK Equity Income sector, which comprises 23 investment trusts. In Exhibit 11, we show the largest seven, which all have market caps in excess of £500m. MRCH’s one-year total return is above the selected stock average, ranking second out of seven funds; however, its returns are below average over the other periods shown. The trust’s above-average discount may be due to its high level of relatively expensive debt, although the recent refinancing announcement may lead to some narrowing of the discount. MRCH’s ongoing charge is in line with the selected peer average, but meaningfully smaller than the whole sector average, and in common with the selected peers, no performance fee is payable. The trust has an attractive dividend yield, which is c 1.5pp higher than the selected group and c 1.0pp higher than the whole sector averages.

There are five directors on MRCH’s board, all of whom are non-executive and independent of the manager. Chairman Simon Fraser was appointed in August 2009 and assumed his current role in 2010. The other board members and their dates of appointment are Paul Yates (March 2011), Sybella Stanley and Mary Ann Sieghart (November 2014) and Timon Drakesmith (November 2016).