The Merchants Trust — Celebrating its 135th anniversary

MRCH has a strong pedigree; having launched in February 1889, the trust is celebrating its 135th anniversary. Gergel aims to deliver a high and rising income and robust capital growth from a portfolio of reasonably priced, primarily UK equities. MRCH is one of just 20 companies in the AIC’s list of dividend heroes, which have increased their annual dividend for at least 20 consecutive years. The trust has a long-term record of outperformance and a competitive fee structure.

MRCH released its annual results; unfortunately, after two consecutive years of outperformance, in FY24, the trust’s NAV and share price total returns did not keep up with the benchmark’s total return. For more detail, please see the following Performance section. MRCH has a competitive fee structure, which ranks highly in the AIC UK Equity Income sector. In FY24, its ongoing charge of 0.55% was 1bp lower year-on-year. Due to strong demand for the trust’s shares, they traded at a premium for a large part of FY24 and c 8.2m shares were issued (c 5.8% of the share base) raising c £46.0m.

Board changes – having each attained nine years of service, two of MRCH’s directors retired, Mary Ann Sieghart on 25 January and senior independent director Sybella Stanley on 21 March 2024; her role has transitioned to Karen McKellar. There are two new independent directors. Lisa Edgar joined the board on 1 January 2024; she was previously chief customer officer at Saga and is founder/CEO of Big Window Consulting, which has meaningful experience in financial services. Mal Patel was appointed on 1 March 2024; he is head of investor relations at Spirax Group and has held a series of senior positions at large UK companies.

The trust’s upside and downside capture rates over the last decade of 125% and 127% are well above 100%. This confirms the manager’s unconstrained approach and his willingness to take stock and sector positions that deviate from the benchmark. With both rates broadly the same, it suggests that MRCH is likely to outperform by around a quarter of the market move when share prices are rising and underperform by a similar degree in a falling market.

At the end of March 2024, MRCH’s top 10 positions made up 35.9% of the portfolio (Exhibit 2), which was a higher concentration compared with 32.9% a year before; seven positions were common to both periods. The portfolio had 50 holdings (excluding derivatives), which was three less than 53 at the end of March 2023.

In terms of market cap, the majority of the fund is invested in large and mid-cap companies, but over the 12 months to the end of March 2024, there was a notable 7.9pp higher weighting in mid-cap stocks (UK 250), with a 5.0pp reduction in exposure to the largest 100 UK companies. MRCH had a modest 3.8% invested in overseas firms compared with the maximum 10% permitted.

In February 2024, Bank of Ireland was added to the portfolio as part of the move to gradually increase MRCH’s bank exposure. The banking sector has been restructured since the global financial crisis, and bank margins are expanding in an environment of higher interest rates. Bank of Ireland operates in a consolidated market where there are just two major Irish banks. This position diversifies the trust’s economic exposure, while the Irish housing market looks more resilient than the UK’s. Bank of Ireland has an attractive valuation and a c 6% dividend yield.

MRCH’s holding in Bank of Ireland was funded by the sale of building materials company CRH, which has changed its listing twice, from Ireland to the UK and more recently to the US (where most of its revenues are generated). CRH re-entered the portfolio in 2022 and its share price subsequently doubled. While the company has delivered a strong operational performance and has good prospects, this has been reflected in its valuation, so the position was sold with the proceeds redeployed into higher-conviction holdings.

There were modest changes in MRCH’s sector exposure in the 12 months to the end of March 2024, the largest were a 3.1pp lower weighting in consumer discretionary stocks and a 3.4pp increase in the industrials weighting. Compared with the benchmark, MRCH’s largest active weights were industrials (+6.4pp), utilities (+4.4pp) and healthcare (-4.5pp).

Gergel remains optimistic about the prospects for UK equities due to overall attractive valuations, a wide dispersion of individual company multiples and anticipated increased interest from overseas investors. While data suggest the UK economy was in recession at the end of 2023, if that proves to be the case, the downturn is likely to be shallow as there have not been widespread job losses, although specific industries have been under pressure. Within the market, a lack of clarity about the path of interest rates has added to share price volatility, with cyclical shares supported when the outlook is for lower rates and vice versa. This uncertainty has led to a narrow market leadership with investors favouring growth stocks that they believe can grow in any environment, and which are generally much more expensive.

The manager believes that this divergence in company valuations is providing opportunities to buy good businesses at discounted levels. He notes that the UK market is trading at close to a 20-year low forward P/E multiple and historical studies show that, on average, the lower the starting valuation multiple, the higher the subsequent equity returns, which adds to his bullish outlook.

While the UK market has been attractively valued for a prolonged period, Gergel believes there is potential for a change in attitude towards UK stocks. Since the June 2016 Brexit vote, the UK political environment has been seen as risky and now, although there is a general election looming, there is not a huge policy gap between the two main political parties. Also, they are both acutely aware of the market reactions to former prime minister Liz Truss’s radical approach of unfunded tax cuts to stimulate growth. UK economic data have been revised up showing that UK growth is not dissimilar to that in other advanced countries, while inflation is continuing to moderate. In addition, what may be overlooked by global investors is that most sales and profits of UK companies are generated overseas. A change in sentiment towards the UK market could provide meaningful support given there have been prolonged fund outflows, which have led to selling of smaller-cap stocks in particular. Recently, there has been a series of acquisitions of UK companies, which if the trend continues could provide further support to the UK market.

MRCH is one of 19 funds in the AIC UK Equity Income sector. Over the last year, the trust’s NAV total return has been negatively affected by some stock-specific weakness and ranks 17th. However, MRCH’s returns are above average over the last three, five and 10 years, ranking fourth, second and sixth respectively. On 29 April 2024, the trust had the second highest valuation in the sector and just one fund was trading at a premium. MRCH has a competitive ongoing charge, ranking sixth, a higher-than-average level of gearing, and an attractive dividend yield, which is c 20bp above the sector mean.

The trust is classified as a mid-cap value fund by Morningstar, along with four of its peers: abrdn Equity Income Trust, Invesco Select UK Equity, Lowland Investment Company and Shires Income. MRCH’s NAV total returns rank fifth out of the five funds over the last year, first over three and five years and second over the last decade.

In FY24, MRCH’s NAV and share price total returns of -3.1% and -3.4% respectively lagged the benchmark’s +1.9% total return. The trust’s performance was negatively affected by an environment of higher interest rates and investor caution, which supported the performance of higher growth stocks. In aggregate, the shares of more cyclical and smaller-cap businesses underperformed. Also, there was a higher-than-average number of holdings with negative stock-specific issues. MRCH’s sector allocation added to performance, such as an overweight position in construction and building materials, with a below-index exposure to metals and mining stocks. However, this was outweighed by individual stock price moves.

The largest negative contributor to the trust’s relative performance was St. James’s Place (-1.1pp) due to a change in its charging structure in response to regulatory developments and media scrutiny (the position was sold as the investment thesis had changed). Diversified Energy (-0.8pp) experienced lower gas prices and a tougher environment for its acquisition strategy as there was increased competition for target assets. Close Brothers (-0.7pp) was involved in a regulatory review surrounding commissions paid on car financing agreements, lower asset prices negatively affected its wealth management business, and investors had general concerns about the cyclicality of the company’s business. Not holding shares in RELX and Rolls Royce each detracted 0.7pp.

On a more positive note, the largest positive contributor to MRCH’s relative performance was DCC (+0.8pp), whose capital markets day highlighted that its energy business is well positioned to help its customers transition away from fossil fuels. Not owning shares in Anglo American, Prudential and Diageo added 0.8pp, 0.6pp and 0.6pp respectively to the trust’s relative performance.

MRCH’s relative performance record is shown in Exhibit 8. It has lagged the benchmark over the last 12 months, but its NAV is ahead over the last three, five and 10 years.

If the final dividend is approved by shareholders at the May 2024 AGM, MRCH’s FY24 annual dividend will be 28.4p per share (c 1.1x covered), which is a 2.9% increase from 27.6p per share paid in respect of FY23. The trust now has a 42-year unbroken record of higher dividend payments; over this period, it has compounded at an annual rate of 6.4%, which is well above the 3.8% annual rate of UK inflation (based on the Consumer Prices Index), thereby providing real income growth to shareholders. MRCH ranks 12th on the AIC’s list of 20 dividend heroes, which are funds that have raised their dividends for at least 20 consecutive years.

In FY24, MRCH’s revenue earnings per share of 30.5p was 6.3% higher year-on-year, marking the third year of income recovery following COVID-19, and 1.8p per share was added to revenue reserves. These now total 18.1p per share, which is equivalent to c 0.6x the FY24 dividend.