Merchants Trust (The) — High and growing dividend yield

UK equities, along with share prices across the globe, have returned to more normal levels of volatility following a particularly benign period in 2017. Ongoing Brexit uncertainty is putting extra pressure on the UK stock market, particularly for shares in companies with domestic, rather than international operations, while global institutional allocations to UK equities remain very low compared with historical averages. Over the last six months, the valuation of UK equities has become more attractive, with lower multiples and higher dividend yields across the market capitalisation spectrum. Although the current investment backdrop presents challenges, it can also provide opportunities for investors with a disciplined, long-term approach to stock picking.

Launched in February 1889, MRCH is one of the oldest investment trusts listed on the London Stock Exchange. Since 2006 the lead manager has been Simon Gergel, chief investment officer of UK equities at AllianzGI, which has c £460bn in assets under management. He aims to generate an above-average level of income and income growth, and long-term capital growth from a relatively concentrated portfolio of c 40–60 UK equities. The manager has a contrarian approach to stock selection, seeking attractively valued stocks that can be held for the long term. MRCH is benchmarked against the FTSE All-Share index (FTSE 100 index prior to January 2017). There are investment guidelines in place to diversify risk; the portfolio must be invested in at least five sectors (with a maximum 35% in each), and there is a limit of 15% in a single holding. Gearing is permitted in a range of 10–25% of net assets (at the time of drawdown); at end-October 2018, net gearing was 20.7%. MRCH has a distinguished dividend history; annual distributions have increased for the last 36 consecutive years, using reserves to supplement income when required. Its yield compares favourably with the majority of its peers (Exhibit 12).

Gergel says that so far in 2018 there have been big swings in sentiment; issues that investors are grappling with include Brexit, the US/China trade dispute, the government budget in Italy, and the pace and magnitude of US interest rate hikes. The manager says an environment of rising interest rates can lead to pressure on equities, as witnessed by weakness in global stock markets in October 2018. He notes a polarisation in the UK stock market, with shares in companies perceived as being able to generate steady growth significantly outperforming the rest of the market. In addition, with continued outflows from UK equities putting pressure on stock prices, the manager is finding a large number of attractively priced investment opportunities. Gergel says the operating environment for UK companies generally remains ‘okay’, but that commentary from Q318 earnings reports suggests that ‘life is getting a little bit tougher’ due to rising raw material and labour costs, and there are specific industries under pressure, such as autos and retail. However, he believes there will be pent-up demand in the UK economy if there is a favourable Brexit outcome.

At the heart of MRCH’s investment process is in-depth fundamental research to identify companies that are trading at a meaningful discount to their perceived intrinsic value. Gergel is able to draw on the well-resourced investment team at AllianzGI to construct a relatively concentrated portfolio of primarily higher-yielding UK equities. He says historical evidence shows that, in aggregate, companies paying above-average dividend yields have delivered higher-than-average total returns as well as a higher level of income. The manager stresses that yield alone is never a sufficient reason to buy a stock, and there is no automatic sale if a company’s dividend yield falls below that of the market. MRCH’s investment process is centred on three pillars – company fundamentals, valuations and external themes – to answer three critical questions regarding the quality of a company’s business, whether its shares are undervalued, and how supportive the operating environment is. Shares are sold when they have reached their target price, if there is a change in the investment thesis, or if there is a more attractive investment opportunity available.

Gergel highlights MRCH’s recent initiation of a position in Imperial Brands. He says he avoided the tobacco stocks for the last year, as he was nervous about structural changes in the industry, including a reduction in demand and the proliferation of next-generation products cannibalising the market for traditional cigarettes. The manager became interested in Imperial Brands after its dividend yield doubled from c 4% in 2016 to c 8% in 2018. He believes the sharp sell-off in the company’s share price is unwarranted, as although Imperial Brands has lower overall volumes – due to reduced demand and from rationalising its long tail of smaller brands – its premium brands are gaining share. He is also encouraged by the company’s line up of next-generation products and its commitment to generate a meaningful percentage of total sales from these products by 2020.

Other new positions in MRCH’s portfolio include ITV and Keller. The manager says the position in ITV is controversial because of the structural pressure on its traditional TV business, due to competition from streaming. However, Gergel says that although audiences are fragmenting, ITV owns the only commercial station in the UK where advertisers can reach large audiences, and he is encouraged by the growth in its studio business (around one-third of sales), which is providing companies such as Amazon and Netflix with valuable content. Keller is a smaller company but is the world leader in geotechnical (ground) engineering. The firm is benefiting from urbanisation trends globally and the replacement of ageing infrastructure. Gergel says that local scale is important; equipment used within the industry does not move around much as ground conditions vary with location. Keller is also growing as a result of bolt-on acquisitions. The manager believes that the company’s valuation is compelling.

Recent disposals within the portfolio include Diageo and Sainsbury’s. Gergel recognises Diageo as a well-positioned, high-quality global spirits company. However, he found the company’s valuation unattractive. The stock has outperformed a weak market, so the manager viewed the modest position as a good source of cash. Sainsbury’s share price rallied following the announced merger with ASDA. Gergel believes the deal makes financial sense, but he has concerns over the timing of the merger, and whether it will gain regulatory approval without significant asset sales. In addition, the manager is mindful of the risks involved when companies enter into transformational deals.

In H119 (ending 31 July), MRCH’s NAV and share price total returns of +7.4% and +8.7% respectively were ahead of the benchmark’s 5.0% total return. After taking financing costs and movements in the value of debt into account, gearing contributed 1.1pp to the trust’s excess return. In terms of individual share price moves, the largest contributors to relative performance were not owning British American Tobacco (+0.7pp), which suffered from weak industry fundamentals, and the position in UBM (+0.7pp), which performed well ahead of its acquisition by Informa. The largest detractor was Standard Life Aberdeen (-1.0pp), which has continued to experience outflows since Standard Life and Aberdeen merged in August 2017; investors were also unimpressed by the terms of the deal to sell its life assurance business to Phoenix Group in exchange for c 20% of the firm and cash.

As shown in Exhibits 5, 6 and 7, in recent months MRCH’s NAV and share price have been negatively affected by volatility in the UK stock market. However, its share price has outperformed the benchmark over one and three months and over one year.

In Exhibits 8 and 9, we show MRCH’s discounts over the last three years with debt at book value and market value respectively. Due to the low level of interest rates, the market value of the trust’s relatively high-cost debt is higher than its book value, meaning that MRCH’s share price discount to NAV with debt at market value is lower than its discount with debt at book value. The trust’s current 0.1% share price premium to cum-income NAV (debt at market value) compares with average discounts of 4.5%, 5.4%, 3.5% and 2.3% over the last one, three, five and 10 years respectively.

MRCH is a conventional investment trust with 108.7m ordinary shares in issue. Following the repayment of the trust’s £34m, 11.125% debt in January 2018, via a £35m, 35-year private placement note at 2.96%, MRCH’s interest costs are considerably lower. Interest is charged 65:35 to the capital and revenue accounts, and costs will be £2.8m pa lower as a result of the debt refinancing. The trust’s debt structure is as follows: a c £45m 9.25% bond maturing in 2023; a c £30m 5.875% bond maturing in 2029; the £35m 2.96% note maturing in 2052; along with £2.6m in 3.65% cumulative preference shares and 4.0% perpetual debenture stock.

AllianzGI is paid 0.35% per year of the value of MRCH’s gross assets (minus current liabilities, short-term loans and any funds within the portfolio managed by AllianzGI), which is allocated 65:35 between the capital and revenue accounts respectively, to reflect the board’s expected split of long-term returns between capital and income. In FY18, the ongoing charge of 0.59% was 4bp lower than 0.63% in FY17.

MRCH aims to generate a high and growing level of income; quarterly dividends are usually paid in August, November, February and May. The total H119 distribution of 12.9p is a 4.9% increase compared with H118. After deducting the H119 dividends, at the end of July 2018, MRCH had a revenue reserve equivalent to 14.0p per share (+5.3% y-o-y). The board intends to pay at least 6.5p per share for the third and final interim dividends in FY19; the minimum expected total dividend of 25.9p represents a 4.4% increase compared with FY18, and a prospective dividend yield of 5.5%.

MRCH’s board is proud of the trust’s dividend history – annual distributions have increased in each of the last 36 consecutive years, and over this time have compounded at a significantly higher annual rate than the level of UK inflation (Exhibit 11, LHS). As shown in the right-hand exhibit above, over the last decade, MRCH has consistently offered a higher dividend yield than that available on the FTSE All-Share index.

MRCH is a member of the AIC UK Equity Income sector, which comprises 24 trusts. In Exhibit 12, we highlight the 12 largest, with market caps in excess of £300m. MRCH’s NAV total returns (with debt at par value) are above average over one and three years, ranking third and sixth out of 12 funds respectively, while lagging over five and 10 years. Looking at the whole sector averages, MRCH is again above the mean over one and three years, ranking fourth and seventh out of 24 funds respectively, while ranking 20th out of 24 funds over five years and ninth out of 23 over 10 years. The trust’s ongoing charge is below the selected peer group average, and it has a higher-than-average level of gearing. MRCH’s dividend yield is the second-highest out of 12 funds (1.2pp above the mean) and fourth out of 24 funds (0.6pp above the mean).

MRCH’s board has five directors, all of whom are non-executive and independent of the manager. Simon Fraser has served as chairman since May 2010, having been appointed to the board in August 2009. He has announced his intention to retire in 2019, so a search for a new chairman is underway. The other four directors are: Paul Yates (appointed in March 2011), Sybella Stanley (senior independent director), Mary Ann Sieghart (both appointed in November 2014), and Timon Drakesmith (appointed in November 2016). The broad prides itself on its diversity in terms of gender, and wide-ranging experience in both investment and corporate commercial environments.