Merchants Trust (The) — Update 9 January 2017

Exhibit 2 (left-hand side) shows the total return and dividend yield of the FTSE 100 index over the last five years. UK share prices have rallied strongly following the post-Brexit vote sell-off and the FTSE 100 index has hit a record high. However, the current dividend yield of the FTSE 100 index is in line with the average of the last five years. As shown in Exhibit 2 (right-hand side), the valuation of UK large-cap companies remains marginally more attractive than for smaller-cap companies on a forward P/E basis and more significantly on a dividend yield basis. For investors looking for exposure to large-cap UK equities, a fund with a long-term record of high and growing income may be of interest.

Launched in 1889, MRCH is a well-established investment trust. It aims to provide a high and growing level of income and long-term capital growth by investing mainly in higher-yielding, large-cap UK equities. Since April 2006, MRCH has been managed by AllianzGI’s chief investment officer of UK equities, Simon Gergel, who runs a relatively concentrated portfolio of c 40-50 positions. MRCH is currently benchmarked against the FTSE 100 rather than the FTSE All-Share index, although at end-November 2016 c 35% was invested outside the benchmark. Gearing as a percentage of net assets (at the time of drawdown) of 10-25% is permitted. No single investment may exceed 15% of total assets at the time of purchase and individual sector exposure is limited at 35% of the portfolio. MRCH has one of the highest dividend yields in the AIC UK Equity Income sector and has 34 years of consecutive dividend growth – this has continued through many economic cycles including the global financial crisis; when necessary, reserves have been used to ensure consistent annual dividend growth.

Manager Simon Gergel comments that the FTSE 100 is outperforming mid-cap stocks for the first time in many years. There has been strong performance from mega-cap companies such as HSBC, BP and Royal Dutch Shell, where MRCH has greater exposure than most of its peers, although it does have c 35% of the portfolio outside the benchmark. MRCH’s near-term performance has also benefited from higher bond yields – in H116, the high value of its debt was a drag as bond yields fell; however, the value of MRCH’s debt has fallen with higher bond yields. Gearing has also enhanced investment returns as the UK market has rallied significantly in recent months.

The manager highlights three areas of the UK stock market that he considers particularly interesting on a valuation basis: mega-caps, telecoms/utilities and recovery stocks. Despite recent upward stock price moves, the manager suggests that some mega-cap companies still offer good value, such as BP, HSBC and Royal Dutch Shell. They have dividend yields of c 6% and Gergel has more confidence in their ability to continue to pay high dividends. A recent addition to the portfolio is BT, where the manager took advantage of a pullback in the share price to repurchase a position; an 8% free cash flow yield is viewed as attractive. Although there have been concerns about the competitive environment, the manager believes that the acquisition of EE ensures that BT has the leading mobile and fixed network and the deal offers the opportunity for major cost savings. In addition, higher bond yields are reducing the size of BT’s significant defined benefit pension deficit. Within utilities, exposure has been added to National Grid; its regulated earnings are protected by an inflation linkage rather than having an allowed fixed rate of return.

With regard to recovery stocks, investors had been paying high multiples for stocks with perceived earnings certainty, such as consumer staples and undervaluing many companies where the earnings outlook is depressed or uncertain. Gergel suggests that this trend appears to be turning as value stocks are recovering and quality growth/momentum stocks are starting to struggle. He highlights Marks & Spencer, where its food business is delivering robust results and the company is generating strong cash flow. However, investors do not have high confidence in management’s ability to turn the clothing operations around. The manager suggests that the company’s CEO is making the right decisions, although it will take time for any turnaround to become apparent.

The UK construction industry has suffered a multi-year decline, but there are now indications of higher construction and infrastructure spending. A white paper on the housing sector is due to be published in January 2017, which should lead to higher activity in the sector. In addition, there are major projects underway such as the Hinkley Point nuclear facility, expansion of Heathrow Airport, the High Speed 2 railway and higher spending on highways.

Manager Simon Gergel aims to generate high and growing income and long-term capital growth from a relatively concentrated portfolio of primarily large-cap UK equities. Stocks are selected based on an investment process that is a blend of three elements: fundamentals, valuation and themes. Fundamental analysis is undertaken to determine industry dynamics and a company’s competitive position, financial considerations focus on cash flow strength as a key driver of performance and the potential for dividends, and a company’s corporate governance record is assessed. When considering a company’s valuation the manager focuses on both absolute measures and relative to its history/the overall stock market as well as dividend yield. A focus on themes takes the macroeconomic environment into account, as well as the stage of the business cycle and any industry-specific or secular issues. Positions may be sold if target prices are achieved, if there is a company/industry change so that the original buy thesis is put into question, or if a better investment opportunity has been identified; a holding is not automatically sold if its dividend yield falls below a certain level. Gergel is able to draw on extensive analyst resources at AllianzGI, which includes GrassrootsSM, a proprietary market research network.

At end-December 2016, MRCH’s top 10 positions comprised 46.9% of the portfolio. This was a modest increase in concentration from 44.0% at end-December 2015; eight holdings were common to both periods. Exhibit 3 shows that over the last 12 months to end-November 2016 there has been a small decrease in exposure to benchmark FTSE 100 stocks, with investment increased in mid- and small-cap companies. The majority of revenue from portfolio companies is generated overseas, such as oil and pharmaceutical companies, which have significant sales in US dollars. In periods of sterling weakness, companies with global operations, which do not hedge their currency exposure, generate higher profits, enhancing their ability to pay or increase their dividends.

Exhibit 4 shows MRCH’s exposure by sector. Over the last 12 months the largest increase in exposure has been oil and gas, while the largest decreases have been consumer services, which remains an overweight position, and consumer goods, where MRCH is significantly underweight versus the benchmark as the manager considers the companies expensive. The largest overweight sector is industrials; holdings include aerospace components company Senior, which is benefiting from Airbus and Boeing ramping up their production schedules. Senior also sells into some cyclically depressed industries such as oil and gas and trucking, which have recovery potential. The manager considers that given the growth in the aerospace industry, it is an attractive time to buy shares in Senior and he believes that the company should be in a position to grow its dividend.

Exhibit 5 (right-hand side) shows the absolute performance of MRCH’s share price, NAV and the benchmark over both the short and long term, while Exhibit 6 highlights MRCH’s performance versus the benchmark FTSE 100 and FTSE All-Share indices. Better relative performance over three and six months has led to higher relative performance over one, three and five years compared to our last review, which was published in July 2016. MRCH’s share price and NAV total returns are now both outperforming the benchmark over five years.

MRCH’s current 5.0% share price discount to cum-income NAV with debt at market value is narrower than the 6.5% average of the last year. Over the last year, the discount has been in a range of 0.2% to 10.9%; the widest discount was on 3 November 2016, a period of heightened investor risk aversion ahead of the US presidential election. The current discount is modestly wider than the averages of the last three, five and 10 years (range of 2.0% to 2.9%).

While interest rates have started to rise, they remain historically low. This means that the market value of MRCH’s debt is higher than its par value (and thus the value of the NAV with debt at par value is higher than the value of the NAV with debt at market value), so the share price discount to NAV with debt at market value is narrower 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. At the end of FY16 (January 2016), MRCH held £110m book value of debt with an average maturity of seven years and an average interest charge of 8.5%. Interest costs are split 35:65 between the revenue and capital account. The first tranche of MRCH’s high-cost debt is getting closer to maturity – the £34m 11.125% debenture is repayable in January 2018. The board regularly considers options for the debt position; if it was refinanced at the current level of interest rates, the manager estimates it would add 3-4% to earnings per share.

In FY16, the annual management fee was 0.35% of net assets, which was in line with the previous year, and the ongoing charge was 0.58% versus 0.62% in FY15. This is in line with the average of the larger investment trusts in the AIC UK Equity Income sector, but much lower than average when compared to all of the peers in the sector.

MRCH has a progressive dividend policy; annual dividends have increased for 34 consecutive years. Exhibit 10 (left-hand side) shows that over the last 20 years, MRCH’s dividend yield has consistently exceeded that of the FTSE 100 index. The right-hand chart illustrates that since the 1980s, MRCH’s annual dividend has compounded at an annual rate of 7.6% versus an average 3.6% annual RPI inflation rate.

Dividends are paid quarterly in August, November, February and May. The 24.0p dividend in FY16 was 0.8% higher than the prior year; it was fully covered by revenue. Revenue reserves of £27.2m at end-H117 (July 2016) were 4.2% higher than the FY16 annual dividend payment. As shown in the following section, MRCH’s current dividend yield compares favourably with the peer group.

MRCH is one of 23 investment trusts in the AIC UK Equity Income sector; Exhibit 11 shows the largest funds with market caps above £400m. MRCH is the only trust benchmarked against the FTSE 100 index rather than the FTSE All-Share index. Its near-term performance versus the peers is improving as bond yields have started to rise, as MRCH has low exposure to bond proxies and higher bond yields are reducing the value of MRCH’s debt. MRCH’s NAV total return is significantly above the selected and sector peer group average over one year, ranking seventh out of 23 trusts; however, it lags the averages over three, five and 10 years. In terms of risk-adjusted returns as measured by the Sharpe ratio, MRCH is above the average over one year, reflecting its improved near-term performance, and is in line over three years. Its discount is one of the widest in the sector, perhaps as a result of its high level of gearing, ranking 19th out of 23 trusts. MRCH’s ongoing charge is in line with the selected average, and in common with most trusts in the sector, no performance fee is payable. MRCH has a significantly higher dividend yield than the sector average; its yield of 5.3% is 1.2pp higher, and 1.6pp higher than the largest trusts in the sector. This may be an important consideration for investors in an environment where asset yields remain low.

There are six members of the board at MRCH; all are non-executive and independent of the manager. Chairman Simon Fraser was appointed in 2009 and elected to his current position in 2010. The other directors and their dates of appointment are senior independent director Mike McKeon (2008), Paul Yates (2011) and Mary Ann Sieghart and Sybella Stanley (2014). On 29 September 2016 the board announced the appointment of Timon Drakesmith with effect from 1 November 2016. He will be chair of the audit committee and is the CFO at Hammerson, a UK REIT, which is a member of the FTSE 100 index.