The Merchants Trust — Update 16 December 2015

At the time of writing there had been no ‘Santa rally’ for the FTSE 100, which has fallen in total return terms by 8.4% from the start of the second half of the year (1 July to 11 December). Investors seemed more focused on the negative implications of the imminent US interest rate rise (principally a stronger dollar, leading to concerns for emerging markets with dollar-denominated debt and outflows of funds causing markets to fall) than the positive signals of recovery in the world’s largest economy. Falling commodity prices linked to a slowdown in China, as well as conflict in the Middle East and beyond, have added to the poor sentiment, outweighing news of a stronger UK economy with rising wages. However, early signs are that the 0.25% US rate rise announced as this note was being finalised has been received positively.

Oddly in the era of quantitative easing and ultra-low interest rates, when income-hungry investors have increasingly looked to the stock market to satisfy their yield requirements, higher-yield stocks (as measured by the FTSE 350 HY index, Exhibit 2) have underperformed the main UK index in total return terms. This is true not just over the whole 10-year period shown in the chart, but in the recovery period over the last three years (FTSE 100 total return of 11.9% versus 7.3% for FTSE 350 HY over three years to 11 December 2015).

In aggregate, no area of the UK stock market looks particularly compelling in terms of price/earnings valuation (right-hand chart, below; figures at end-November). The FTSE 100 P/E is c 37% above its five-year average, and in absolute terms is similar to the valuations of the mid-cap FTSE 250 and FTSE Small Cap indices. However, if high valuations suggest limited capital growth potential in the immediate term, it is important to note the role of dividends in total returns. While some concerns exist over dividend cover for FTSE 100 stocks (see The manager’s view), the FTSE 100 dividend yield is comfortably above those of its smaller-cap peers, and also above five and 10-year averages.

Launched in 1889, The Merchants Trust has evolved throughout its history into an investment trust seeking a high and growing income from a portfolio of UK equities. It is managed by Simon Gergel, chief investment officer of UK equities at AllianzGI, and is both the largest and the oldest of the three trusts managed by AllianzGI. MRCH is differentiated from peers in the UK Equity Income sector by using the FTSE 100 index as a performance benchmark; the trust currently has a slant towards some of the largest stocks in the index, although it also has c 35% of assets invested in companies outside the 100 largest. MRCH is one of the highest-yielding equity investment trusts and has a 33-year record of annual dividend growth.

Manager Simon Gergel points out that while recent years have not been kind to some of the largest companies in the FTSE 100, there is no reason to believe that problems such as the bursting of the TMT bubble, the financial crisis and the collapse in commodity prices – which in turn have affected telecoms companies, banks and oil and mining stocks – should recur. MRCH aims to provide a high yield as well as the prospect of growth in income and capital, and Gergel argues that companies in these out-of-favour areas are trading at more attractive valuations and at higher yields than in-demand sectors such as consumer staples.

With the aggregate dividend cover (the ratio of earnings to dividends) of the FTSE 100 declining over recent years, some commentators have raised concerns over the sustainability of dividends from large UK companies. Gergel expects modest dividend growth next year for the MRCH portfolio, which, though concentrated in a fairly small number of stocks, is diversified by industry and has about one-third of assets invested outside the FTSE 100. While dividend growth from the largest stocks (particularly oil and gas, currently c 14% of the portfolio) may be subdued, and there may be some dividend cuts, this should be offset by higher dividends from smaller stocks and names like Lloyds Banking Group, which is expected to resume significant dividend payments for the first time since the financial crisis. Overall, the manager expects MRCH’s dividend growth to exceed that of the FTSE 100, particularly given the low level of exposure to under-pressure mining stocks. Gergel points out that in a world of low interest rates and low inflation, low dividend growth would be expected. However, several portfolio stocks across a range of sectors, including a trio of insurers (L&G, Aviva and Prudential), Pennon, Inmarsat, Kier and Britvic, are growing their dividends at a healthy rate.

Some 3.5% of the portfolio is in companies that are not immediately expected to pay dividends; this includes long-term holding Mothercare, where a continued turnaround in the UK would allow the rating to reflect strong growth overseas. Because MRCH is not constrained by only holding stocks that pay a dividend, it is able to hold positions such as this at modest valuations, providing the potential for superior capital growth as well as future income.

MRCH manager Simon Gergel aims to build a high conviction portfolio of c 40-50 stocks to achieve a high initial yield together with income growth and the possibility of capital appreciation. Stocks are chosen for their total return (not just income) potential. All holdings should yield at least in line with the market within 18 months, but this does not preclude those that do not currently pay dividends.

Potential holdings are assessed according to their fit with portfolio themes, absolute and relative valuation, and fundamentals such as industry dynamics, competitive position, corporate governance and financials. AllianzGI’s large team of industry specialists conducts more than 5,000 company meetings each year, and Gergel can draw on their recommendations, as well as the output of GrassrootsSM, a proprietary research system with a network of analysts and field researchers. Stocks may be sold if they achieve their target price, if there is a change to the investment case, or if the manager sees better opportunities elsewhere. A fall in yield to below the market level (whether caused by a dividend cut or by an increase in price) will not necessarily lead to an exit.

The manager makes selective use of option-writing to enhance portfolio income. This facility is most likely to be used when market volatility is higher, as low volatility tends to translate to low option premiums. Options may be written over a maximum of 15% of the portfolio.

At 31 October 2015, MRCH had 44 holdings, with 44.4% of the portfolio held in the top 10 stocks. This compares with an average stock list of 58 and a top-10 concentration of 34% for the AIC UK Equity Income sector. Just under half the stocks by number, representing about one-third of the portfolio, are outside the benchmark FTSE 100 index. The short stock list means the portfolio is actively positioned versus the benchmark, as shown in Exhibit 3 below. However, Gergel’s tilt towards mega caps (seven of the 10 largest UK stocks at 10 December are in the portfolio) means that there is also meaningful exposure to overall index movements.

At an absolute level, the largest sector exposure is to financials (25.2% of the portfolio at 31 October), which includes the recent purchases of Lloyds, Barclays and Prudential. The largest overweights (Exhibit 4) are in consumer services and industrials, both areas that should benefit from an improving UK economy. Utilities – a high-yielding area – are also overweight, while the oil and gas exposure is largely in line with the benchmark. The biggest underweight is in consumer goods, where a flood of investors seeking ‘bond proxies’ has pushed up prices and valuations to historically high levels, resulting in lower dividend yields. Gergel says that rising interest rates will mean investors begin to question the value of these defensive stocks, and that a healing economy should feed through into greater interest in cyclical stocks.

Recent changes to the portfolio include the increase in financials detailed above (+5pp over six months), as well as the purchases of financial support services firm Equiniti and low-cost accommodation booker Hostelworld at their IPOs. The latter is an example of a stock where GrassrootsSM research was used to assess the investment opportunity, with market research carried out in the UK and Germany. Sales include Cineworld, Unilever and retail property company Hammerson, all of which had performed strongly, and the underperforming oil services stock Amec Foster Wheeler and mining spin-off South32.

While the equity portfolio is entirely invested in UK stocks, the earnings of particularly the largest companies are international. Gergel says that while 70% of holdings report their earnings in sterling, with the majority of the remainder reporting in US dollars, the UK/overseas split of earnings for the portfolio is similar to that of the FTSE 100, with c 60-70% of earnings coming from outside the UK. This means the trust may also benefit from economic recovery in the US and Europe.

MRCH has been hit by the sell-off in FTSE 100 stocks in the second half of 2015 (index total return -7.3% over six months to 30 November), exacerbated by the impact of gearing in a falling market. However, over three and five years and in most cases over 10 years, the trust has outperformed the FTSE 100, FTSE 350 Higher Yield and FTSE All-Share indices in both share price and NAV total return terms (Exhibit 6).

Gergel takes a long-term and value-focused approach to investment, and some more recent additions to the portfolio, such as copper miner Antofagasta and Lloyds and Barclays banks, remain quite depressed in share price terms. However, other holdings such as Mothercare, cruise operator Carnival (a double beneficiary of the low oil price owing to lower costs and higher disposable incomes) and brokerage ICAP (which recently announced a partial merger with rival firm Tullett Prebon) have contributed positively to the portfolio.

At 15 December, MRCH traded at a 3.2% discount to its cum-income net asset value with debt at market value. (Because of the current low level of interest rates, the market value of the debt is higher than its par value; this boosts the NAV with debt at par, meaning the discount on this basis is wider, at 8.0%.) The current discount is wider than the one-, three- and five-year averages (2.8%, 1.2% and 0.3% respectively), possibly as a result of large-cap UK stocks being less favoured by investors, and there is scope for it to narrow, particularly given MRCH’s high dividend yield.

The trust may repurchase up to 14.99% and allot up to 5% of issued share capital annually, to manage a discount or a premium. So far in 2015, no shares have been issued or bought back.

MRCH is a conventional investment trust with one class of share (108.7m ordinary shares in issue at 11 December). Structural gearing of c 20% comes mainly from two issues of debentures totalling £79.7m (par value), repayable in January 2018 and May 2023, as well as £29.5m of secured bonds. With the repayment of the 11.125% 2018 debentures only two years away, the board is starting to consider options such as refinancing or repayment, the first of which could boost portfolio income by c 3-4% given the relatively high cost of debt servicing, while the second would be largely revenue neutral.

AllianzGI is paid an annual management fee of 0.35% of assets minus current liabilities. Ongoing charges were 0.59% for the year ended 31 January 2015.

Dividends are paid quarterly, in August, November, February and May. For FY14/15 the total dividend was 23.8p, with the third and fourth quarterly dividends raised to 6.0p per share compared with 5.9p for the first two. For FY15/16 two dividends of 6.0p per share have so far been declared; if the third and fourth quarterly dividends are maintained at the same level the total dividend for the year would be 24.0p per share, an increase of 0.8%, extending the unbroken run of year-on-year dividend increases to 34 years. The payment of the FY14/15 dividend necessitated a small contribution from revenue reserves (0.2p per share), which remain large at 24.7p per share at H115/16, sufficient to cover a full year’s dividends. Based on the 15 December share price of 408.8p and the FY14/15 dividend, MRCH currently has a yield of 5.9%.

The AIC’s UK Equity Income peer group has 25 constituents; Exhibit 10 below shows the largest seven, with market capitalisations above £400m. MRCH is unusual in the group because it measures its performance against the FTSE 100 rather than the FTSE All-Share. The recent spell of more challenging performance has translated into below-average NAV total returns over one, three and five years. However, MRCH does have highest yield of the large funds and the fourth-highest in the whole sector, providing an important source of return during a period where positive capital returns from equities may be harder to come by. In a sector where 10 funds currently trade at a premium to NAV (driven by appetite for income-producing assets), it is significant to see one of the highest-yielding trusts on an above-average discount. This may be related to the relatively high level of structural gearing, which is the fifth-highest in the sector. Ongoing charges are broadly average and there is no performance fee.

MRCH has five non-executive directors. Chairman Simon Fraser joined the board in 2009 and has held his current post since 2010. Mike McKeon has been a director since 2008, while Paul Yates was appointed in 2011. The newest directors, Mary Ann Sieghart and Sybella Stanley, joined the board in November 2014. The directors have backgrounds in investment management, industry, corporate finance and the media.