The Merchants Trust — UK market is ‘a stock picker’s dream’

Gergel has managed MRCH since 2006 and has followed a disciplined investment process based on three pillars: fundamentals (focus on a company’s industry structure and competitive position, its financial metrics and ESG factors); valuation (in absolute and relative terms, along with dividend yield); and themes (industry and secular issues, the macroeconomic outlook, and the stage of the business cycle.) In essence, the manager seeks quality businesses that are trading at a discount to their estimated intrinsic worth. Gergel is prepared to back the courage of his convictions by investing in out-of-favour sectors and has adhered to the trust’s long-term successful investment process, including through difficult periods of relative performance.

MRCH’s cumulative upside capture over the last decade is 127%, which is modestly higher than its 124% downside capture, showing that on average the trust performs slightly better on a relative basis in a rising than a falling market. These figures are meaningfully different than 100% (which would imply that MRCH generally trades in line with the UK market), illustrating Gergel’s unconstrained approach and his willingness to have sector and stock weightings that differ markedly from the benchmark.

An industry that Gergel currently finds interesting is housebuilding. While other investors may shy away from these businesses given rising mortgage rates and a cost-of-living crisis, the manager takes a longer-term perspective and believes that with depressed industry valuations, coupled with structural demand for more housing, housebuilding stocks are an attractive investment opportunity.

Reflecting the trust’s relatively low portfolio turnover, which was c 28% in FY23, there were only small changes in MRCH’s sector exposure in the 12 months to end-August 2023. The largest were a 2.9pp higher weighting in industrials and a 3.4pp lower allocation to consumer staples stocks. Versus its benchmark, the notable differences are overweight positions in industrials (+5.3pp) and utilities (+3.4pp), with underweight exposures to healthcare (-3.6pp) and basic materials (-3.1pp).

Exhibit 4 shows MRCH’s market cap and geographic exposures. In the year ending 31 August 2023, there was a notable higher allocation to midcap stocks (UK 250, +10.1pp) with lower weightings in large cap (UK100, -4.7pp) and small cap (-2.7pp) stocks. There were negligible changes in the trust’s geographic exposure over the period.

At end-August 2023, there were 52 (non-derivative) holdings in the portfolio, which was the same number as 12 months earlier. The top 10 made up 33.9% of the fund, which was less than 35.7% a year earlier; six positions were common to both periods.

In August 2023, the manager sold MRCH’s BMW position, as it had performed well, and paid significant dividends, despite a challenging consumer backdrop. The automotive industry has benefitted from high new and used-car prices, due to supply issues, during and after the global pandemic. As supply constraints are easing and consumer budgets remain under pressure, Gergel decided to lock in profits.

The manager initiated a position in XP Power, which is a manufacturer of a broad range of power supplies. These products can be mission critical and designed for specific applications, providing XP with a meaningful barrier to entry and the ability to generate high margins. The company has a blue-chip customer base and structural growth opportunities, for example, from the healthcare, semiconductor and industrial sectors. Gergel was able to buy XP’s shares at an advantageous price as the company had to deal with issues including supply-chain interruptions during COVID-19, an inventory rebuild and a downturn in the semiconductor industry. The manager anticipates that XP’s historical growth profile will resume.

In June 2023, Gergel sold MRCH’s two small positions in Vodafone Group and Ashmore Group, which had proved disappointing. Vodafone has suffered from competitive challenges in the mobile phone industry. The position was initiated during the pandemic in anticipation of an acceleration in the company’s business growth, but this has not materialised. According to the manager, Ashmore has a competitive advantage in emerging market asset management, especially in fixed income. However, the business is cyclical and fund outflows have put additional strains on the business. Subsequent to the sale, Ashmore reported results, which included an increase in its variable compensation, and its share price has continued to languish.

There was an above-average level of portfolio activity in May 2023. Inchcape returned to MRCH’s portfolio, as it has a strong position operating as an agent for car manufacturers in overseas areas, such as for Toyota in Hong Kong. The major automobile companies are focusing on the larger regions, encouraging Inchcape to take on more franchises in smaller markets that were being served by independent companies, who are struggling to supply the required software and services. Inchcape’s share price de-rated following an acquisition of a business in Chile, providing Gergel with a favourable entry point.

There is a new position in Marshalls, which is a provider of building products for new build, refurbishment and commercial properties. The industry is under pressure in a higher interest rate environment, while the company acquired Marley (a roofing specialist), which increased its debt level. Gergel believes that Marshalls is a good-quality business that is temporarily depressed.

The manager is bullish on the outlook for the reinsurance sector due to firm pricing and a lack of new capacity. He switched MRCH’s position in Swiss RE into Lancashire Holdings on valuation grounds. There was also a relative valuation switch in the banking sector as Gergel sold the trust’s holding in NatWest Group and reinvested the proceeds in Lloyds Banking Group, which having had to fund its pension obligations is now in a better position to return cash to shareholders.

Back in April 2023, the manager sold MRCH’s position in BAE Systems, which is the UK’s largest defence contractor and had been in the portfolio for many, many years. Having been a very important contributor to the trust’s performance (BAE’s share price had doubled in 18 months), Gergel considered that the company was fully valued.

The manager comments that the UK is one of the least expensive markets with a forward P/E multiple of around 10x, which is at the low end of its 20-year range, unlike the US, which is trading around 20x and at the high end of its 20-year range. Gergel notes that the UK remains polarised, providing good opportunities for active stock pickers. At the end of H123, 43% of the UK All-Share index was trading at or below a 10x forward P/E multiple, while 16% was on a multiple above 20x.

According to the manager, the last few months have been difficult for value investors, which has provided additional interesting opportunities. He suggests that while there are pockets of weakness in the UK economy, such as housebuilding, where businesses are being negatively affected by higher interest rates, operationally most sectors are performing ‘fairly well’.

The UK has been out of favour with international investors and there have been significant fund outflows since the June 2016 Brexit vote. However, Gergel opines that the policy gap between labour and the conservatives is very narrow, with leaders of both parties being more centrist than their predecessors, so a change in government is unlikely to be a stock market-moving event. The manager suggests that to a certain degree politicians are constrained by asset markets, pointing to the violent moves in equities and bonds in response to former Prime Minister Liz Truss’s radical proposals around tax cuts and government borrowing.

Gergel comments that the UK is not an outlier in terms of its economic performance, particularly given the recent material upgrades to historical growth by the Office for National Statistics. He anticipates that there will be more takeovers of UK companies and an increase in share repurchases, which should support the UK market. Using history as a guide, a market that starts to perform relatively better than other regions tends to attract additional buyers.

There are 20 funds in the AIC UK Equity Income sector. On 5 October, MRCH’s NAV total returns ranked second over the last three years (26.1pp above the mean) and fifth over the last five years (8.8pp above the mean). The trust’s returns were below average over the last one and 10 years, ranking 17th and 14th respectively.

MRCH’s valuation was above the sector average, and it was one of five funds trading at a premium. It had a higher-than-average level of net gearing and a dividend yield that was 50bp above the mean, ranking fifth.

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

As shown in Exhibit 8, MRCH has given back some of its relative performance over the last six months so now trails its benchmark over the last year. However, it is comfortably ahead of the broad UK market over the last three, five and 10 years in both NAV and share price terms.

Gergel explains that performance ‘has been tricky’ so far this year. Growth stocks have recovered, having derated in 2022, and mid- and small-cap domestic businesses, where MRCH is overweight versus the benchmark, have underperformed. The manager suggests that the trust’s underperformance in recent months in essentially a mix effect rather than as a result of stock-specific issues.

Looking at MRCH’s performance over the last 12 months, positive contributors include: BMW (automobiles & parts); CRH (construction & materials); Conduit Holdings and SCOR (both non-life insurance). Not owning Diageo (beverages) has also added to the trust’s performance.

Stocks that have detracted from MRCH’s performance include IG Group Holdings (investment banking & brokerage), which experienced softer trading in Q223. St. James’s Place (investment banking & brokerage) reduced the pricing for some of its longest-serving clients. Mobico Group (formerly National Express Group, travel & leisure) struggled to find enough drivers and then had to increase drivers’ wages. Stocks that have performed well and are not represented in the portfolio include HSBC (banks) and Rolls Royce (aerospace & defence).

Having increased its dividends for 41 consecutive years, MRCH ranks 12th on the AIC’s list of 20 dividend heroes (funds with at least 20 years of consecutive dividend growth). Over time, the trust’s dividend growth has meaningfully exceeded the rate of UK inflation, thereby providing real income growth to shareholders.

MRCH’s FY23 fully covered annual dividend of 27.6p per share was a modest 1.1% increase yearon-year. Demonstrating its confidence in the trust’s portfolio income generating ability, the board has announced two 7.10p per share interim dividends in respect of FY24, which are 3.6% higher than the 6.85p per share first two dividend payments for FY23. At the end of FY23, MRCH had revenue reserves of 16.3p per share, equivalent to 0.6x the last annual payment.