The Merchants Trust — Higher dividends for the last 41 years

Gergel explains that UK equities were resilient in 2022 and generated a positive return, unlike most other markets. However, this has gone by relatively unnoticed as UK equities have generally been out of favour with global investors since the 2016 Brexit vote. As a result, in aggregate, UK company valuations are very attractive both on an absolute basis and versus global equities.

The manager says that the UK stock market is home to many large international companies operating in interesting industries. However, the UK stock market has a different mix compared with other equity markets, with less high-growth and technology exposure, and higher weightings in more traditional areas such as mining, banking and consumer goods, which were more resilient in last year’s particular market environment. Gergel suggests that investors had become a bit more interested in the UK but then the global pandemic occurred and the war in Ukraine added to inflation pressures, which led to further outflows from the UK and very modest UK equity valuations.

Given this valuation backdrop, the board increased MRCH’s gearing from c 12% to c 15% in November 2022; gearing had declined due to strong markets and the trust’s robust share issuance. The manager explains that MRCH’s portfolio yield is around 4.5% and the cost of debt is just over 4.0%, so even if there is no capital growth, a higher level of gearing should be beneficial to the trust’s total returns.

Gergel comments that when assessing companies as potential investments, there are three areas he considers: fundamentals, valuation and themes. Fundamental analysis includes a firm’s business model, its competitive position, its financial profile and ESG credentials. In terms of valuation, does a company offer good value versus history and other opportunities in its sector? Themes refers to a consideration of structural trends and risks, industry cycles and avoiding value traps; these are companies that appear to be inexpensive, but have problems that are not reflected in their current share prices.

The manager comments that there are times when he has to take a step back during periods of high stock market volatility, such as around the Brexit vote, during the global pandemic and following the war in Ukraine. He stresses the importance of taking a longer-term (ie three- to five-year) view about whether businesses will recover, as you cannot predict what will happen in the six to 12 months after a major market-moving event. Gergel says he has to determine whether an investment case has changed, if not, share price weakness could be a good opportunity to top up a portfolio holding. However, if a business has been compromised, it may be better to sell the position. He opines that humility is an important attribute for a successful fund manager.

MRCH has exposure to the housebuilding sector. The manager explains that it is a consolidated industry because it is difficult to set up a new company due to planning rules, tough regulation and acquiring land. He says the housebuilders in the trust’s portfolio have strong land banks, good records of high returns and robust balance sheets with net cash; prior to the global financial crisis, housebuilders had net debt positions, but have since learned their lesson. Gergel notes sector valuations are modest, with housebuilders trading at a discount to the value of their land banks, while they offer attractive dividend yields. In terms of long-term themes, the manager says the UK has a housing shortage and there is long-term demand for homes. He comments that there is no doubt that housebuilding is a cyclical business and if volumes and prices decline there will be a short-term hit to profits. However, he suggests that businesses can be reset, as costs will also decline and profits can recover quite quickly.

In January 2023 Gergel initiated a position in Pets at Home Group, which is a UK market-leading retailer, selling both in-store and online. It has scale advantages, such as the ability to develop its own brand range of pet food and nutritional products. The pet industry is relatively resilient, with consumers prioritising spending on their pets during periods of economic weakness. Pets at Home also has a vet services business. Vets4Pets is one of the UK’s largest chains with more than 400 practices, often co-located within its stores. Most of these are joint ventures, with Pets at Home providing capital and support services, while allowing vets considerable autonomy to manage their businesses like entrepreneurs. This business model provides considerable two-way cross-selling opportunities. Although the vet services business only represents a small percentage of Pets at Home’s sales, it generates nearly one-third of the company’s profits. The manager believes that the high quality and growth potential of the vet business is not reflected in the firm’s valuation. The holding was added to the portfolio following share price weakness in the retail sector in 2022.

Gergel added Admiral Group to MRCH’s portfolio in December 2022. It is the UK’s market leader in car insurance, benefiting from a cost advantage versus many of its peers, allowing it to generate superior returns over a business cycle and increase its market share. Admiral is slowly diversifying into UK home insurance and international car insurance. Over the last year, the whole insurance industry has suffered from significant inflationary cost pressures, which have negatively affected its profitability. However, this has resulted in sharp policy price rises, which should benefit future profits. Admiral’s share price fell sharply in 2022, which provided a good opportunity for the manager to invest in a high-quality company with an attractive dividend yield.

MRCH’s relative performance is shown in Exhibit 3. Gergel has continued to build on the trust’s positive track record over the last six months and is ahead of the benchmark over one, three, five and 10 years, in both NAV and share price terms. The outperformance over the last decade is particularly noteworthy given that during most of this period, investors favoured higher-priced growth stocks rather than undervalued names.

Over the last year, the best contributors to MRCH’s relative performance include: HomeServe (a home emergency repairs and improvements company, which was acquired by Canadian firm Brookfield Asset Management); BAE Systems (a multinational arms, security and aerospace company); and Imperial Brands (one of the world’s leading tobacco companies).

The largest performance detractor was AstraZeneca, which is not represented in the trust’s portfolio. Gergel explains that he only initiates a position in companies where he has a positive view. He considered that AstraZeneca’s valuation was not compelling, plus he had concerns about some of the company’s accounting policies and level of cash flow generation. MRCH’s major pharma exposure is via positions in GSK and Sanofi.

MRCH is the sixth largest member of the 20-strong AIC UK Equity Income sector. The trust’s total return ranks first over three years; it is 38.4pp higher than the sector average and 8.5pp higher than that of the second-ranked fund. MRCH’s returns are also above average over the other periods shown, ranking ninth over the last 12 months, fifth over the last five years and seventh over the last decade. The trust is one of four funds in the sector that are currently trading at a premium. It has a competitive ongoing charge and an average level of gearing. The trust’s dividend yield is 40bp higher than the sector mean.