Don’t worry if you missed this week’s popular virtual event with Merchants Trust (MRCH) fund manager Simon Gergel, you can watch the whole one-hour programme now!
In his presentation, Gergel explains how he picks a balanced portfolio of cheap but good ‘value’ stocks that have driven the trust’s long-term performance and underpinned its 41 years of rising dividends.
He goes on to highlight the ‘unprecedented’ value available in the depressed UK stock market as it trades at a 20-year low versus the US and with a 50-year wide dispersion between growth and value stocks, which he argues make a good platform for a sharp recovery if interest rates have peaked.
Following this Gergel answers many questions from Citywire’s Gavin Lumsden and the viewers on a range of stocks and issues such as dividends and market risks.
Can’t watch now? Read the transcript
Gavin Lumsden:
Hello and welcome to the ‘Unprecedented opportunity in the UK stock market’. A one-hour programme brought to you by Citywire and Allianz Global Investors. My name is Gavin Lumsden, I’m from Citywire. With me is Simon Gergel, fund manager of Merchants Trust, who’s here to discuss what he’s called the stock pickers’ dream, presented by the current depressed valuation of UK equities. Simon, very good to see you again.
Judging by the large number of you who’ve signed up for this event, it could be the tide is turning, as investors look for a recovery in share prices, if interest rate rises and inflation start to abate. After my introduction, Simon’s going to give a presentation. I’m then going to ask him a few questions and after that, it’s over to you for Q&A.
Simon, are you ready to tell us about Merchants and why you’re so positive about the UK stock market?
Simon Gergel:
Thanks, Gavin. Yes. Delighted to be here today. I think it’s a great opportunity for the UK market and I will talk about that. I’m going to start by talking about the Merchants Trust. Giving an introduction to the viewers as to what we’re doing. So, if you look at the agenda, I’ll give a brief introduction of the trust. Talk about how we pick stocks, what we do in the trust, how we invest, then spend most of the session talking about the opportunity today, which is really quite remarkable. Then a little bit on dividend income, performance and gearing, which investment trusts have. Then conclusion and go back to your questions. So, let’s kick on.
In terms of overview. First thing to say is Merchants Trust has been around a very long time. It’s an investment company designed to invest in the stock market. Particularly, predominantly in large UK companies to deliver a high and rising income stream and good capital growth. We have grown the dividend every year for 41 years. We’ve got significant reserves to allow us to do that. We have a strong performance record, driven by high conviction active stock-picking approach with a value style. I’m sure we’ll come back to that. We’ve got a modest management fee, one of the lowest in the sector and a very strong board of independent non-executive directors who are there, as you know, to represent the shareholders. They’re independent of us, the managers.
So, without further ado, in terms of the investment process, what we’re trying to do from a philosophical point of view, is we’re trying to buy materially undervalued companies. Sounds quite easy, but in order to do that, I think you need two things. You need firstly, to be quite opportunistic. Good companies don’t often get materially undervalued and at the moment, there’s quite a lot, but often they don’t. So, you have to be a bit opportunistic. We tend to be quite contrarian, looking for value where there might be a known issue or a question mark over a company. When we’ve got ideas, we tend to be fairly concentrated. We want the ideas in the portfolio, the stocks to deliver individually important contributions. We don’t want to have 150 companies.
The other important aspect, though, is to manage risk. We think very carefully about the risk of individual companies and the risk at portfolio level. When we think about company risk, there’s really three types. There’s operational risk, what could go wrong in the business. Financial risk, the amount of debt and leverage and then there’s valuation risk. If you pay too high a price for a company, even if it delivers operationally, you might lose money if the valuation goes down. That’s a part of the process, happy to take questions on that.
Just a word on income. We are trying to deliver a high and rising income stream and we fish in the pond of high-yielding stocks. There’s a lot of evidence that over time, high yielding companies have tended to perform better than low yielding companies. The chart here is a very long-term chart looking at America and breaks down the market by decades, since 1941 and in most decades, high-yielding shares have outperformed low-yielding shares. The obvious and notable exceptional has been the last decade, to 2021 where high-yielding shares did particularly badly in America. Over the very long term, investing in higher dividend shares, higher yielding shares, has actually outperformed in both America and the UK, which might be slightly counterintuitive. Having said that, we don’t just buy companies with a high yield. In fact, the dividend yield is not the reason for us buying a stock.
We fish in that pond, but we want companies where we can make a good total return and our investment decisions are driven purely by total return considerations within that universe. For the same reason, we don’t automatically sell a share if the dividend yield drops below a certain level. If the share price goes up, the yield drops, there’s no automatic sale.
So, what do we look for? We look for three things. We look for strong fundamentals, which is essentially, the business model. The competitive position of the company. What products has it got, what services? What’s its brands, technology, intellectual property, that type of thing? We look at the other aspects of the business model. We look at the management structure. The governance and the environmental and social risks in the business. So really, building a broad picture of, is this a good business?
The second thing we look at is valuation. We want companies, good businesses that are cheap. We look at a number of measures. I think the most important is probably, cashflow. We want companies that can generate significant and sustainable cashflow and we don’t want to pay too much for that.
There are other measures like asset value and so on, which come in from time-to-time in certain sectors. Then the third thing, having identified good businesses that we think are cheap, is we say, what’s going to change? We want companies that are ideally exposed to positive themes like demographic changes or digital trends. If there are negative themes, we need to be all over them. That’s often where our biggest discussions, our biggest debates and analysis go, is trying to understand the themes that are affecting the business in the medium to long-term. That’s a simple explanation.
Strong Inchcape
To give you an example, a company we bought in the last year, we’ve actually owned this before, Inchcape (INCH). It’s probably the leading distributor of cars in the world, outside of the big car companies, outside of the big markets. So, they’re not selling cars in retail show rooms, but they are effectively, the manufacturer’s agent in various markets. They distribute Toyota in Hong Kong, for example and have done for 50-plus years. Car distribution used to be-, they’ve got a strong position. The business has a broad spread across markets, particularly emerging markets. Where the brand owners don’t want to do it themselves. They make very attractive returns, margins and return on capital. So, it’s a strong business with a good market position.
In terms of trends and themes, what you’re seeing is increasing consolidation. So historically, a brand like Mercedes would have a small distributor in many of these emerging markets, often a family-owned company. As the market gets more sophisticated, as the buyers increasingly come online and want to buy a car digitally and if the car companies want to interface digitally with the customers and make sure they have proper cybersecurity protection and so on, you need much more sophisticated systems and technology. So, this industry is consolidating. The brand owners want to work with very strong partners who have those digital skills. So, you’re seeing consolidation. The other theme that is good for Inchcape is, they have a lot of exposure to emerging markets where car penetration is low and rising faster.
So, it’s faster growth in many of those markets and there’s also a digitalisation trend, which I touched on. In terms of valuation, this company was fairly highly valued a couple of years ago when we sold out. Then it got derated for various reasons and these valuation numbers actually, are a few months old. It’s cheaper than that now. It’s trading on a mid-single-digit price earnings ratio. Attractive dividend yield, very strong cashflow. So, it’s a low valuation. Particularly given the quality of the business and the returns they make. So that’s a good example of our process in action.
Risk control
In terms of the overall process, just very quickly, we start with idea generation, looking for companies that meet our criteria. We then analyse the in-depth, in terms of fundamentals, themes and valuations. We try and build a portfolio of 40 to 60 companies, and this is where we really think about the risks at the overall portfolio level. We want to make sure we understand how exposed we are to cyclical companies or defensive businesses, international or domestic, various risk factors, as well as sector-by-sector, what are our exposures. So, although we’re bottom-up, we do then think about how it looks overall at the portfolio level.
Finally, the sell discipline is just as important as the buy discipline. We’re very disciplined. If the investment case changes, we will absolutely review it and may well sell it. If there are better opportunities elsewhere, that could be it and of course, if valuation moves up and gets to where we think it’s fair value, then we will sell out as well. So all of that goes together to build the portfolio.
Astonishing UK market
So that’s a very quick run through, I’m conscious I’ve sped through it a bit. I’m happy to take questions later, but I think what I wanted to talk about mostly today, is the opportunity today, in the UK equity market because it’s quite astonishing, what’s going on.
If we start with an overview. Clearly, it’s a challenging economic background. There is a risk of recession.
[TEN MINUTES]
We’ve got much higher interest rates than we’ve been used to and companies are facing a number of challenges that they haven’t seen for a while. There was a lot of supply chain disruption during Covid. Now, there’s a question mark about demand, consumer demand, corporate demand. Companies are a bit uncertain with that. You’ve got a bit of destocking going on, as companies have built up inventories and they’re now winding them down. You’ve got higher interest rates. So, when companies refinance, it’s now costing more, rather than costing less, which for most of the career of most of the people running businesses, it’s got cheaper every time your refinance. So that’s a very different set of circumstances.
There’s also a challenge of deglobalisation. Companies are having to put more of their production closer to the end-markets, rather than in the cheapest possible place, which is both for political reasons and geopolitical reasons, but also, for environmental reasons, to reduce the supply chain. That’s adding cost and complexity. There may be some savings down the road, but generally, deglobalisation is adding complexity and cost. So, there’s a number of challenges and of course, labour costs are still rising rapidly. Having said that, there are some things going the other way. Commodity costs have rolled over, even energy, which is a bit higher today, than it was a few months ago, year-on-year we’re not seeing the inflation we were seeing last year.
We’ve seen unemployment remain low. So, most people are-, most countries have good employment, high employment, which is supporting the economy. It looks like bond yields and interest rates, I dare not say may have peaked, but certainly, we’re nearer to the top, hopefully and at some point, expectations may have peaked. I think in the UK, interest rate expectations may have peaked already now. We’re certainly at that point now, where sentiment could swing dramatically, if we start to see interest rates come down. The market’s priced the bad news. Cyclical shares are very depressed in terms of valuation and I’ll come onto this in a minute, but the UK’s got lots of opportunities.
Glass half full
The chart on this page, very complicated chart, but essentially, it’s showing the mix of the UK stock market, who owns it. Back in the late 1980s and early 1990s, when I started my career, half the UK market was the pink and salmon colours or red and salmon colours, which were domestic insurance companies, institutions, and pension funds. They own about 4% of the market now. So, they’ve sold out almost entirely, for lots of different reasons. Half of the market is now owned by foreign investors.
Now, the good news about that-, that has its challenges of course, because foreign investors want to buy the market, if they want to buy UK and they haven’t done I the last few years. That could change, if sentiment to the UK improves as people could come in and there could be a lot of buying and there’s not much left to sell from the domestic institutions. So, I see this as a glass half full rather than a glass half empty, but clearly, it has been a big challenge over the years.
Just a few statistics. On the left-hand side of the page in front of you, we look at the valuation of various markets around the world. This is from Goldman Sachs. UK, on the righthand side of that, is trading at ten times earnings. It’s right at the bottom of its 20-year range, how much you pay for a pound of profits, you pay £10. America, on the other hand on the left-hand side, is trading at 20 times. You’re paying $20 for every dollar of profits and that’s right at the top of their long-term range. So, you’ve got this quite unusual situation where the UK is very cheap versus history at the same time as the US and many other markets are quite expensive. Then within the market, on the right-hand side, distribution of valuations is incredibly wide.
So not only is the market cheap compared to history, but there’s a very broad spread. The gap between value and growth or really, the gap between highly-rated and lowly-rated stocks, is as wide as we’ve seen it in 50 years, wider than it was during the TMT [technology, media, telecom] bubble in 1999. So that’s a fantastic opportunity for stock pickers because you’ve got a cheap market and lots of opportunities and a broad spread within that.
Just a bit more background. The next chart shows the way the UK market as derated since 2016. I’m sure you remember what happened in June of 2016, there was the Brexit referendum. Ever since then, the UK stock market has got cheaper and cheaper compared to the world average and there’s a whole raft of reasons that people might have cited the risk of a change of government with Jeremy Corban, when he was leader of the opposition. The pandemic, which hit the UK quite hard. The Ukraine war, which has hit Europe overall, hard, as well as the UK because of higher exposure to energy prices. The last year, of course, we had the Liz Truss mini budget and most recently, and I’ll come back to this, the narrative that the UK somehow has a worse problem from a growth point of view and inflation point of view.
All these challenges have led to the UK being out of favour and there’s been almost no buyers. The only buyer that’s left really, has been the corporate sector and the other chart on this page shows that corporates have become net buyers. The green bars going up are corporates issuing stocks, they’re raising money and the green bars going down, are companies buying back stocks. Companies have been buying back a lot of their equity. (a) because they’ve got cashflow and (B) because their equity is very cheap, but in many cases, the buyer of last resort. That’s a really unusual situation as well. So, we think there’s a lot of opportunity. The market is very depressed, so we think that’s interesting.
Just coming back to this narrative about whether the UK really has a worse problem than the rest of the world, what we saw in September was the growth statistics were significantly revised up and it’s quite a hard chart to see here. Essentially, what it’s showing on the left-hand side is that UK economic growth is bang in the middle of the pack in the G7. It looks exactly the same since the pandemic, as elsewhere around the world. In fact, inflation, which did look high and sticky, is now coming down quite sharp. Inflation expectations, which is even more important, are back to normal. So, the UK was perceived to have a worse problem in terms of lower growth and higher inflation. I think that was not really justified and certainly, given the latest data, doesn’t really seem that justified.
So, you’ve got a very lowly-rated market with an economy that’s performing in line with other countries. I think politically, I think the gap between the Conservative and Labour is incredibly tight now and politicians have learnt that the markets really decide what they can do and can’t do. So politically, we don’t see that much risk in the UK either, which is where the UK historically was before the last five or six years.
So just a few more slides. If you break down the UK stock market into buckets of valuation, on this chart the light blue colour, about 15% of the stock market is on a price earnings ratio of over 20. There’s a chunk of the market on quite high ratings and there’s a very large part of the market below ten times earnings, but very little in the middle. So, you’ve got this polarised stock market and if you look at our portfolio, we’ve got two-thirds of our stocks on a single-digit price-to-earnings ratio now, which is really remarkable and very little at the higher end. So, the market is very polarised and we have our portfolio very much at the cheaper end of the market. Of course, price doesn’t equal value, but we think we are buying really good companies, as well as the fact that they are lowly priced.
Mid-cap buyer
On the next page, just a list of the new companies we’ve added and companies we’ve completely sold in the last 12 months. I won’t go through this, except to say that the overwhelming feature is where we’ve put most of the new money has been into the mid-cap area, which has been particularly out of favour. When investors sell the UK and don’t want to have exposure to the UK, they really generally mean the mid-cap area, which tends to be a little bit more domestic. Tends to be a bit more cyclical than the large, mega-cap, the mega cap oil companies, or companies like Unilever and so on, which are very much global businesses. The mid-cap area has been particularly out of favour with investors and that’s where we’ve found a lot of the best opportunities.
Some of the themes, some of the stocks in the portfolio. Just to pick out one theme. The whole energy transition. There’s lots of ways to get exposure to the energy transition, which I think is going to be very powerful theme for investors, for decades ahead, probably. We’ve got exposure through companies that are buying copper, for example, and aluminium, which are metals that are pretty critical to distributing electricity and generating electricity. We’ve got companies like SSE (SSE) and Drax (DRX), which are renewable power generators and distributors in the case of SSE. Then we’ve got companies that are producing gas, which is increasingly replacing either coal or other dirty fuels in the energy mix. So, there are interesting ways to play various themes and good companies on attractive valuations.
If you look overall, at our portfolio, in terms of the mix, we have slightly less in what we would call defensive stocks. So more resilient businesses, less economically sensitive and we’ve been reducing that. I should say really, we’ve been adding to slightly more cyclical areas where we’re seeing better value. So overall, we’ve got-, we don’t have that much more in highly cyclical companies, but in the moderately cyclical area and the uncorrelated cyclical area, we’ve got quite big positions. We’ve been taking down and reducing defensive weightings in the last year or so, where valuations have been fuller and we haven’t seen such good opportunities.
[TWENTY MINUTES]
I’m going to jump through the next page because that’s just the top 20 holdings and the sector positions, very happy to come back to that in questions if there are and people can see that on our factsheets.
Growing dividends
I want to say a few words about dividends and performance because clearly, we had these two objectives to deliver a high- and rising-income stream and good performance. In terms of dividends, this chart shows the last 41 years, where Merchants has raised the dividend every single year. We also show the way that the board can use reserves. Can put money away in good years, which are the green bars, when income is above the earnings-, sorry, earnings are above the dividend and can draw on those reserves in tough years such as 2021, 2022 during the pandemic, to keep growing the dividend, even when income is under pressure. That cycle works very well over time and we’re now back in a situation where the dividend is covered by earnings and the earnings are growing quite nicely and we had 16p of reserves at the end of last year, which is about half a year’s dividend. So that process, which is a unique feature of investment trusts, that you can put money away in good years to use on a rainy day like today, that process has worked very well for Merchants over the years.
The other thing to say is, the other objective is total return and we show three lines here, just to confuse people. We’ve got the share price total return, we’ve got the net asset value total return, which tends to be very closely related, of course, and then we’ve got the benchmark return and we’ve delivered very strong performance compared to the benchmark, over the last decade, despite having a value style at a time when value investing has generally been really out of favour, really quite tricky. So, we’re very pleased with the performance we’ve delivered, albeit, this year’s been challenging and I’m sure you’ll ask about that.
Finally, investment trusts can borrow, can gear. We have about £110m of debt. The average cost of debt is around about-, well, it was 4.7% at the beginning of the year, it’s probably 5% now, but it’s come down significantly from where it was five or six years ago, when it was 8.5%. Much of that debt is locked in either a medium or long-term borrowing. So, it’s quite modest cost. So that structure is very well positioned. The idea of gearing is to deliver a higher total return and higher income over time, if the portfolio can deliver more than the cost of debt. Given the yield on the portfolio is about 6% today, we think the portfolio total return should be above the cost of debt. Of course, borrowing does make things more volatile and it adds literally, gearing as volatility to the portfolio, which is something shareholders need to be aware of.
So that’s the presentation, just to conclude where we started. High yield, very important that we grow the dividend every year, that’s an important objective of the board. We’ve got a strong record, based on high conviction active stock selection and a modest management fee within the sector and a strong board.
Recession fears?
Gavin Lumsden:
My questions would start with, last month was a tough one for the UK stock market. There are signs that interest rates may have peaked. Does this latest decline reflect fears that the UK will fall into recession because of the impact of the rate rises we’ve had so far?
Simon Gergel:
It’s hard to know. I think the UK market’s been following the lead from the US. In the US, what you’ve seen actually, is bond yields going up even further. I think long bond yields are very close to 5% and that is squeezing sentiment. Sentiment is quite depressed generally and the UK tends to follow the US in the short-term, in terms of valuations. So, I’m not sure that investors are looking at the UK economy and saying therefore, because we’re worried about the UK economy, the stock market should go down. I think it’s more that high bond yields in America are sucking money out of the equity market and making people a bit more nervous, generally. Actually, the economic news in America in terms of growth, are not too bad, but sentiment is pretty depressed or at least has got worse shall we say.
Will growth beat value?
Gavin Lumsden:
So, you’re a value investor. You like to buy good stocks when they’re cheap. Isn’t the growth style likely to do better than value, as interest rates peak and investors look for companies that can do well in a difficult economic environment?
Simon Gergel:
It’s always a really tricky question as to when value and when growth will do well. I think there’s potentially, two counteracting forces. The first thing is, value investing is a bit like a piece of elastic. You can stretch the elastic. Valuations can get cheaper and cheaper and we look at how stretched that elastic. At the moment, the gap in valuations between value and growth or between-, within the market dispersion’s incredibly high. That elastic’s very stretched. Now it could get more stretched if you think or if the hypothesis that we’re going to go into a deep recession, cyclical companies might get even more depressed. They are already pricing in a lot of bad news and many of the banks are on really very depressed valuations.
On the other hand, if there’s any sign of improvement, any sign of sentiment improving, sometimes, interest rates falling actually leads people to be a bit more optimistic about the market. You could see a snap back very quickly, of valuations. So, it’s hard to predict, but the more stretched that elastic is, the cheaper the valuations are and the dispersion there is the market, the more opportunities there are for value investors. So, I can’t tell you when that’s going to change, but I wouldn’t necessarily assume that just because interest rates come down or just because the economy is difficult, value stocks will do very badly. In fact, if you look at 2000 and 2001, post the TMT bubble when the economy was pretty weak, value shares did really, really well in that environment as growth derated.
Gavin Lumsden:
That’s right. On that note, what sorts of opportunities have the recent falls opened up for you?
Simon Gergel:
Well, I touched on some of them earlier. So, we’re finding opportunities in the mid-cap area across the market really. Some of them are businesses like Inchcape, which are actually, global businesses, they’re not really UK businesses, they just happen to be listed here. We’re finding opportunities in reinsurance, in some of the consumer areas, in some of the building related areas. In the last 12 months we’ve bought Pets at Home, which is a pet retailer and, also, veterinary business, which is a more resilient type of activity. We’ve also bought companies like Grafton (GFTU) and Marshalls (MSLH), which is the building materials area. One’s a distributor, one’s a manufacturer, but those companies are priced for a lot of bad news. We think on a three-to-five-year view, they’re offering really good value.
Does Merchants face competition from bonds?
Gavin Lumsden:
Looking at Merchants own share price, having traded at a premium for quite a while, as the value style was coming back in favour, but Merchants shares recently have moved to a small discount, it’s about 1%, but are the share price ratings of other UK equity income trusts have also weakened. I just wondered, is that because of the competition from higher interest rates on cash and the high yielding government bonds? Also, National Savings has recently announced they’ve raised £7.7bn in September, for its high yielding bonds. So there seems a lot of competition out there potentially.
Simon Gergel:
There is competition from higher interest rates than we’ve had for many years, but there’s also nervousness in the market and when that nervousness ends, I don’t know. You could see if people start to get-, well, firstly, interest rates could-, people’s expectations of interest rates could come down if inflation continues on a downward path, but I think you’ve got to look at a trust and in the case of Merchants, the dividend yield’s nearly 6% and that dividend yield should hopefully grow over the medium to long-term. Historically, it has done. Equities give you not just income today, but they give you the potential for capital growth and income growth into the future. So, you’re looking at two very different options. Sticking money in the bank or bonds or buying equities. I wouldn’t give advice, it’s not my area, but there’s also an element of risk appetite.
How nervous are people and when people are nervous, they tend to stick with cash and bonds. When they’re a bit more optimistic, they tend to move to the equity market. I would say from here, given the opportunities, it wouldn’t take much money going back into the equity market to potentially make a big difference to valuations because most of the sellers have sold really.
How are the banks doing?
Gavin Lumsden:
As you say, the potential for growth UK equity income funds like yourselves are offering. You hold just over 21% in financials. It’s been a difficult few months, as well, for the UK banks. I wondered, what did you think of their recent third quarter update? Particularly Lloyds (LLOY), where you switched into from NatWest (NWG) in May.
Simon Gergel:
Yes. We did switch from NatWest to Lloyds. I would say the most important decision is how much do you want in the banking sector and the big banks, we quite like some of the small banks as well, rather than the choice between Lloyds and NatWest and Barclays (BARC), which we also own. That’s a second order magnitude difference. I think the time horizons of the market have come right down and volatility has increased and people have got nervous. So, investors seem to be incredibly focused on one quarter’s numbers and interest margin trends, which are getting a little bit weaker in the short-term. Lloyds results, actually, were a bit stronger than NatWest, which had a slightly bigger problem.
So, I think Lloyds did better on results day than NatWest, but that’s not really part of our thinking. We’re looking three to five years ahead. We see the UK banks as having this structural hedge.
[THIRTY MINUTES]
They essentially hedge out some of their lending and their borrowing over a long period of time, which means that that smooths the impact of changes in interest rates. They’ve got a tailwind to come from previous money that they’ve leant out at quite a low rate, which is going to reprice upwards over the next two or three years. So over time, their income should actually improve, or their hedge should benefit the business. In the short term there’s a lot of noise. There’s some depositors taking their money out of interest-free accounts and move them into higher interest accounts, which clearly reduces the income the banks are earning.
We do see over the medium-term, not only the banks continuing to make good money, but actually, we see scope for their interest margins to improve because of the structural hedge. The other thing I would say is, they’re now generating a huge amount of cash. So, if you go back to a company like Lloyds, for many years there were PPI mis-selling costs, there were pension costs which were eating away at some of the cashflow. Most of those have fallen away now and the earnings they’re reporting are feeding through into cash, into very healthy dividends and the case of many of the banks, buybacks as well. So, the cash return for banks is really extremely high and we don’t see much of a credit risk. Obviously, there’s economic sensitivity, economic risk, but at the moment, the banks look to us to be quite conservatively run.
Much more conservatively, clearly, than they were before the financial crisis. The regulatory environment is chalk and cheese compared to what it used to be. So, we see the domestic banks as quite interesting places to invest. That 21% in financials, I should say for the benefit of the viewers, is very well spread between financial companies like IG Group (IGG), wealth managers, insurance companies. We like the reinsurance sector quite a lot. As well as banks and other financials.
What do oil mergers mean for Merchants?
Gavin Lumsden:
Not just banks, that’s a good point. Moving to another sector. Last month saw two huge oil company acquisitions in the US. Chevron buying Hess for $53bn in shares and Exxon snapping up Pioneer Natural Resources for nearly $60bn. What implications do these mergers have for your holdings in Shell (SHEL) and BP (BP)?
Simon Gergel:
I think it’s a sign that there is value in these companies. That they’re generating huge amounts of cash and they have an attractive valuation, they can be attractive to other people. Shares in BP and Shell have both performed quite well over the last 12 months as investors, I think, have started to realise that these companies are churning out huge amounts of cash, paying out dividends and buying back stock.
Gavin Lumsden:
Could they come under pressure to merge? To create one UK champion?
Simon Gergel:
I’m not sure about that. I mean, it’s possible. I don’t think they need to. I think the benefits of scale-, I mean, both of them have enormous scale. I’m not sure there’s much of an additional benefit. Clearly, you could have one head office and one management structure and you could definitely take a lot of cost out, but in terms of operational scale, they are quite diversified and they’ve got fairly well entrenched strategies. So, I’m not saying it could never happen, but it’s certainly not something we would necessarily anticipate in our investment process. I’m not sure it’s necessary from a scale point of view. It’s not like they’re subscale businesses.
Gavin Lumsden:
What bearing does these mergers have on climate change and the push for renewable energy because it’s been noticeable that US companies have done less on renewables than the UK majors?
Simon Gergel:
Yes, that’s a whole big area isn’t it. I think we like the transition approach of companies like BP and Shell. We think they’re getting the balance broadly right between the need to continue to produce hydrocarbons for energy security, increasingly gas, which is lower carbon intensity and lower carbon oil fields, which-, but also, to invest in new areas. In EV charging, in potentially, hydrogen, carbon capture and storage and areas that can lead the transition. I think the UK and European companies generally are getting the balance right in that or more right. I think the US companies and I’m not an expert on US companies, they’re clearly generating huge amounts of cash, but they’re not potentially thinking as far ahead as some of the European companies. I think each company has to do their own thing within their own structure.
In terms of the companies we invest in, we are comfortable with the way that BP and Shell are addressing it. In fact, if I would go even further and say companies like BP and Shell are actually crucial to the energy transition. If you want to move fleets of trucks from diesel to hydrogen, somebody needs to work with those fleets to guarantee them supply in different distribution depots, petrol stations and gas stations, literally will be, hydrogen stations potentially. They need to buy and sell huge amounts of the commodity on the trading markets and hedge that. They need to have the capability to move very flammable and dangerous fluids and gases around the country. These are all the skills that BP and Shell have. So, if you want to do the energy transition quickly, we need to use those companies, rather than try to recreate it all from scratch. So, we are big believers in investing and engaging with these companies, rather than divesting from them.
What overseas stocks do you hold?
Gavin Lumsden:
You’re a UK equity income trust focused on the UK, but you can hold overseas stocks. I’m just wondering what overseas stocks you have left after recently selling Swiss Re and BMW?
Simon Gergel:
At the end of September, we had three effectively. We had Sanofi, which is a pharmaceutical company. We had SCOR, which is another reinsurer. So Swiss Re and SCOR are both reinsurers and we do have UK reinsurance companies as well and we have CRH which used to be UK listed, of course and famously moved to the US market as its prime listing quite recently. So those are the three. We can have up to 10% of the portfolio outside of the UK, but it’s very much a rifle shot. If we find really good ideas we want to buy, we will do that if we don’t have any compulsion to own non-UK stocks.
Gavin Lumsden:
Last question from me. We’ve got lots of questions from the viewers, that’s great. I was curious. Shares in Rolls Royce (RR) have doubled this year following the arrival of a new chief executive. You weren’t a holder. I know you can’t be expected to get everything right, but I’m curious to know why Rolls Royce didn’t come up or make the grade as a value stock at the start of the year?
Simon Gergel:
That’s quite an easy one really. As I said at the beginning of my presentation, we tend to focus on high-yielding stocks. So, it didn’t have a dividend yield, it has a very low dividend yield. So, it wouldn’t qualify for a type of stock that we want to own, which is an income stock. Therefore, we didn’t really spend much time doing the work on it. I think it’s been a very difficult company to analyse because it’s been pretty opaque in terms of its cashflows. Clearly, it’s starting to recover now.
What happens to Merchants’ dividend in a recession?
Gavin Lumsden:
Thank you, Simon. That’s my questions. So, it’s the viewers’ turn. A lot of interest in dividends and on the income. So, I’ll start with a question, actually, from Jason Nightingale, who submitted this in advance. He was asking about the revenue reserves, which I think you’ve covered. His other question was: ‘In a hard recession, with individual companies cutting payouts, what action would Merchants take to minimise any shortfall in its dividend payment?’
Simon Gergel:
Well, the first thing to say is we have a dividend that’s covered by earnings. So, there’s a bit of a buffer before we even need to think about further actions. On top of that, we have the reserves, which are there for a rainy day. So, if we do get a severe recession, where a lot of dividends are cut, then the board could draw on those reserves. I think 2020 was very unusual, the pandemic. Not only were dividends cut, sometimes dividends were cut after having been announced, declared, which was very unusual. Because there was such an uncertainty about what was going to happen. I think, within our portfolio, many of the businesses we own are actually quite resilient. Whether that’s utilities like SSE and National Grid (NG). Whether that’s companies like GSK (GSK) in pharmaceuticals or Unilever (ULVR) in food producers.
So many of the companies are not that economically sensitive, but there are elements that are. So ultimately, if the earnings fell significantly and the company ran out of reserves, revenue reserves, the board would have to look at that and have a discussion with us and say, what’s the best thing to do? The company does have the capability to pay dividends out of capital and there’s a lot of capital reserves. That’s not been necessary, they’ve not had to use that. I can’t speak for the board, but I suspect, if there was a situation where, for a short period of time because you could see earnings recovery, that the board might be willing to dip into capital reserve to keep growing the dividend, but we’re a long way off having that discussion. At the moment actually, the trends we’re seeing in the market generally, are pretty resilient on dividends.
If you take some of the biggest, most volatile sectors for income, energy, banks, they’re both seeing good dividend growth and pretty solid earnings and cash generation. So, things could get worse, they have done in the past, but they’d have to get a lot worse for us to have a problem at the moment on income.
What’s your view on high yielders like M&G?
Gavin Lumsden:
Another viewer was wondering what your thoughts were on high yielding stocks like M&G, which I think you sold and Aviva, do you hold?
Simon Gergel:
We don’t hold Aviva (AV) and you’re right, we did sell M&G (MNG). We only had a very small position in M&G, which I’d inherited from the position in the Pru because they demerged that a while ago. It was never a high conviction position of ours and we tidied up the portfolio and rotated. We do own Legal & General (LGEN), which has a very high yield and we have other stocks in the portfolio with high yields. So, we look at every company under the same sort of lens, which is, do we think we can make good return from it?
[FORTY MINUTES]
Do we have a positive investment case? We haven’t had a positive investment case on those other stocks. It doesn’t mean we’re negative, but there’s a lot of opportunity. You asked earlier about financials. There’s an awful lot of financial companies with good dividend yields and we have found plenty of companies that we have a positive investment case on. So, we don’t own those at the moment, but it doesn’t mean we’re negative on them.
Do you buy low yielders?
Gavin Lumsden:
It links with my question on Rolls Royce, but Alan Kerr asks: ‘How often do you wish you could buy shares, but cannot due to dividend and income constraints?’
Simon Gergel:
Occasionally, to be honest. There are one or two stocks you think I’d like to own that, but it’s funny how often it works that you’re better off waiting. Sometimes, there might be a company that yields 2.5% or 3%, it doesn’t really yield enough for us to buy it, but it’s a good business. You sometimes get a chance. Unilever was a good example. We didn’t own Unilever for a long time. The shares came back, the yield went up, we had an opportunity to buy it and we made good money with it. Same with Relx (RELX). So, it’s a discipline that it can occasionally stop you buying one or two stocks, but equally, it can mean that when you do buy companies, you get in at a very good time. So, I think overall, I’m very comfortable with it, but yes, there will inevitably be one or two companies that with a different approach, we might have been able to buy. Clearly Merchants’ investors, our shareholders, want a high and rising income stream, as well as a good total return.
What’s different about the UK now?
Gavin Lumsden:
Going back to the main part of your thesis really, David Kelly looking at the UK market. In your own words, regarding Inchcape, it is cheaper now. The UK market is also an opportunity, but he complains. ‘We’ve heard this many times from well-known UK fund managers, so why is it different this time?’
Simon Gergel:
I think there’s a great Warren Buffett quote isn’t there? ‘The market is, in the short-term, a voting machine and in the long-term is a weighing machine.’ So, the market’s voting at the moment. People are saying I don’t want to own UK companies and we’re seeing selling. As you said earlier, some people are putting money in the bank, some people are buying international shares, but ultimately, the market function will weigh those shares, will say what are they really worth? If public investors don’t buy them, corporate investors will. We’ve seen a few cheeky takeover bids in some very small companies like Pendragon (PDG), like SCS Sofas I think it was, recently. At quite big premiums, big approaches.
I think you’ll see corporate buyers coming in because many of the businesses we own like Inchcape or like some of our building companies, are global businesses or US businesses, very attractive in their industries and corporates might be attracted. Private equity has got a lot of cash sitting in the wings. Question about whether they can always get the debt finance at the moment, but they will be back. So, if the market doesn’t do its job and prices companies correctly, somebody else will at some point. Of course, companies are buying back their stock as well. So ultimately, I think the market will price it, but exactly when is a great question and I wish I knew the answer. I think it would be a much easier job if I knew that answer.
As you say it’s been frustrating, but I think what we’ve seen previously in these situations, we had one in 2020, we had to some extent, in 2019 when Jeremy Corban was leader of the opposition, we had these periods of dislocation in the market that can have a very sharp snapback when sentiment changes.
Are investment benchmarks to blame?
Gavin Lumsden:
We’ll look out for that then. We’ve got a professional investor watching as well. Don’t have the name, but asking, ‘Do you believe that the asset allocation to UK equities in many of the benchmarks that are used for discretionary investment management is a significant contributor the reduction in UK equity ownership?’ You were highlighting the reduction in institutional and insurance company ownership. ‘As an investment manager’, the person goes on to say, ‘who runs discretionary portfolios, we’re having to reduce exposure to UK equities in order to remain in line with the benchmark.’
Simon Gergel:
Well, that person probably knows more about the way wealth managers and IFAs work and the benchmarks they use than I do. I think what we have observed is that wealth managers have taken their UK equity weightings down much, much lower than they’ve historically been. Many of them are underweight whatever benchmark they’re using. In fact, I’ve met some who’ve had zero in UK equities, which is quite extraordinary, given it’s the domestic market. Whereas in the past, I would say most wealth managers in the UK were probably over-represented in the UK. I’m not sure that’s the case now. I think there’s a lot of people, if investors get more excited about the UK, the market could move and there could be a lot of pent-up buying demand. It’s a hard question for me to answer to be honest.
What are Merchants’ biggest risks?
Gavin Lumsden:
Sounds like some of the wealth managers and their clients might miss out on that rebound if and when it happens. Mark Partington is asking: ‘What are the biggest risks to the portfolio and do you buy any tail protection?’
Simon Gergel:
We don’t buy tail protection in terms of derivative protection, if that’s he’s asking for. We are fully invested in the market. Biggest risks. I think there’s clearly economic risks and that would feed through. If you had a sharp recession, a deep recession and you get high unemployment, that could feed through and probably would feed through to the earnings of more cyclical areas. Housing, banking, consumer, those areas of the market. I think the other risk is probably-, but I think a lot of that’s priced in already. I think the other risk is the US stock market or the global market comes down. The US market, as I said earlier, is quite highly rated, although, sentiment has returned a bit recently. Historically, when the US market comes down, it’s quite hard for the UK market to go up in absolute terms.
Because the US market is more expensive than its recent history, there is a chance I suppose, that the US market comes down with higher interest rates and it’s unlikely that the UK would make good progress in that environment, but I do think the UK market on a medium-term view, offers good value. I suppose, those are the main macro risks. Obviously, at the individual company level, there are all sorts of risks on individual businesses. We don’t avoid risk. It’s probably worth saying. We quite like uncorrelated risk. So, if you take reinsurance, I’ve mentioned it a couple of times. The reinsurance sector clearly has a lot of exposure to natural catastrophe risks. We think that those risks are uncorrelated with economic risk, generally. We think you’re being paid a lot of money to take those risks as an investor today.
Therefore, we quite like taking that risk. It doesn’t mean that we won’t have a bad year for reinsurance markets if there are natural catastrophes, but we think on average, that will smooth out over time and from here, we think we can make good money in those stocks. So, there are a number of individual risks and individual companies, but what we want to try and avoid is correlated risks where large parts of the portfolio are vulnerable to the same factor.
Gavin Lumsden:
Sticking with that theme and market risks, John Michael Williams asks: ‘Despite your optimism, I’m nervous about a fall in the market, given the impact of Ukraine, the Gaza war and China’s threat to Taiwan, for example. Have you underestimated future risks?’
Simon Gergel:
That’s almost impossible to answer that. Have we underestimated past risks is, I suppose, a question we could try and answer. It’s very hard. We tend to look at the opportunities in front of us, look at the companies. We’re much more micro, individual company driven, than we are macro driven. We find some really compelling businesses with strong balance sheets, with great market positions. Often decent growth prospects in the medium to long-term and if we can buy those at attractive prices and lock them away for a while, we think we can make good returns. Trying to speculate on whether we’ve underestimated future risk is really hard to do. Clearly, lots of things can go wrong, but also, I’d say there’s an old phrase, markets climb a wall of worry. Markets tend to do quite well from periods where people are very pessimistic (a) because valuations are low and (b) because sentiment generally gets a bit better or a bit less worse as Sir Martin Sorrell used to say.
So, I think at a time when people are really fearful, is an interesting time to look at the market. Warren Buffett said ‘Be greedy when others are fearful.’ I think, as an investor, you should try and avoid saying today is a riskier environment than it was before and try and say what are being priced for today? The markets pricing in a lot of bad news.
Where is Merchants’ revenue coming from?
Gavin Lumsden:
Turning to the income theme, there was a question about, John Thompson’s asking about: ‘I notice you have a significant holding in BAT (BATS), British American Tobacco. How is the trust invested in terms of where the underlying company’s income is generated between the UK and outside the UK and how does this compare to the FTSE All Share?’
Simon Gergel:
Very good question. What we do in our analysis is, we break each company down. A big picture between a global business, a domestic business and what we call a hybrid, which is somewhere between the two. So, BAT would be a global business, very little in the UK. Company like National Grid would be hybrid because it’s 50/50 UK/international.
[FIFTY MINUTES]
When we look at that and we do that for the FTSE 350 as well, for the largest companies, so most of the market and we compare ourselves. At the moment, we are slightly overexposed to more domestic earnings than international, but not massively. So, we’ve got about 35% I would say. 35% to 40% of the underlying revenues, profits or our businesses coming from the UK, which is a bit more than probably, 25% to 30% in the market.
It’s very hard to get exact numbers, companies don’t actually disclose UK/international. Let me say, they don’t all disclose it in the same way. So, it’s quite hard to know, but we think we’re a little bit over-exposed to the domestic market and that’s partly because we’ve been adding to some of the more domestically orientated and mid-cap areas. If you look at some of the big companies we don’t own like HSBC (HSBA), like AstraZeneca (AZN), they’re very global. Although HSBC obviously owns a UK bank as well. We’re a bit over-exposed to the domestic economy, but now massively so. We’re not 80% domestic. Actually, worth saying two-thirds is international. So even for a portfolio that’s more domestic than elsewhere, two-thirds of our portfolio is exposed to what’s going on in the world and not the domestic economy. We spend a lot of time talking about what’s going on with the domestic economy. We shouldn’t really, a lot of what we invest in is global.
Buybacks or dividends?
Gavin Lumsden:
There’s a global dimension there, clearly. Great. You’ve alluded to the fact that companies seem to be returning a lot of cash to shareholders as buybacks. So, one of our viewers wonders: ‘As an income manager, do you agree with this approach or would you prefer higher dividends to be paid?’
Simon Gergel:
We want companies to do what is right for the long-term value creation. So ideally, what we like for companies is firstly, obviously, they have to spend the money on supporting the business, underpinning the business. Making sure it is sustainable in all sorts of ways and potentially, can grow. If it creates value as a business, you want the companies to invest organically. Where they’ve got surplus cash, if that surplus cash is pretty reliable and dependable, then a chunk of it, we would suggest should be paid out as a regular dividend.
If that’s an area they’re very comfortable, very confident they can, every year, pay year-in-year out, pay a sustainable and hopefully, growing dividend, then we’d support that. Then surplus cash beyond that, which is a bit more variable, we would suggest either they pay it back-, if they don’t need it for acquisitions, they don’t need it in the business, either they pay it back in special dividends or in buying back shares. The driver for that should always be, are those shares offering value? So, if the company’s shares are cheap and by buying back stock they can enhance the value per share of the business, we would urge them to do that. If the shares are fully valued or overvalued and very few companies tell us that, but logically, they should give money back as special dividends.
One company that does this very well is Next Plc (NXT). They’re very explicit about what price they will buy back shares and above what price they’ll pay special dividends. That is the logical way to run a business. What we don’t say to companies, because we’re income investors we want you to pay more dividends. We don’t think that’s the right approach at all. We want companies to pay what’s appropriate for that business and then we will decide, as investors, whether we want to invest in them.
Do you still hold XP Power?
Gavin Lumsden:
Sticking with dividends but moving on to specific stocks. Mark Beeney’s got a question about XP Power (XPP), which you’ve recently disclosed on the factsheet that you bought. He says: ‘The dividends are now suspended.’ So his question is: ‘Are you still a holder? What’s your view?’
Simon Gergel:
I can’t talk about specific companies in the last month in terms of what we’ve done with them, but in general-, I can talk very generally about our approach. Firstly, XP Power I think, is a really strong business in terms of its market position. They make power supplies. A lot of those go into equipment for manufacturing semiconductors or healthcare equipment. Very specialised pieces of kit. These power supplies are designed in and once they’re designed in, it’s very expensive for the manufacturers to take them out again because of the specifications. Over time, the company can make high margins, high return on capital and has grown nicely. So, it’s a good business. We did see an opportunity to buy it. In the short-term life has got more tricky for them, from a balance sheet point of view and they’ve had to suspend their dividends.
In general, our approach, there’s no automatic sell, just because a company cuts a dividend. I did say it in my earlier slide that the yield doesn’t drive-, once we own a company, the yield doesn’t drive the investment decision. We will think about it from a total return point of view. So, we’ll take a view about whether we still believe in the investment case. Whether it’s been fundamentally challenged or not and if we still have confidence in it, we may well stick with it, in general I’m talking, not specifically. If we’ve lost confidence in it, we may well sell it, but a dividend cut per se is not a reason for us to sell a share. We saw that in 2020, many companies cut their dividends during the pandemic. We stuck with the vast majority of them, many of them we added to, actually and generally, that was the right thing to do.
Do you regret holding St James’ Place?
Gavin Lumsden:
One more stock question. St James’ Place (STJ), the wealth manager, shares have had a really tough time because of changes to its charges it’s had to implement in response to regulatory initiatives it would seem. So the question is: ‘When did you buy in because you’ve been a holder for a time and do you have any regrets or have you still got conviction in the company?’
Simon Gergel:
It’s going to be a similar answer. We’ve owned St James’ Place for two or three years. I can’t remember exactly when we started buying, but we have built a position. It is a very strong businesses, in terms of its franchise. It’s the leader in adviser wealth management in the UK. They’ve got the largest team of advisers. They’ve been very successful, have grown the assets under management under advice and it’s been a very powerful income and cash generator over time. I think fundamentally, it remains a very powerful business, but they have made a very major change to their pricing regime. It’s not all negative in that they have cut fees and they’ve got rid of initial charges, but they’ve also removed this situation where for five or six years, certain other assets were not earning them a fee because they were rebating it to customers.
So, if you take a long-term view, the cash generation potential of the business hasn’t actually altered that much, but in the short-term, not the very short-term, but in the two-to-three-year view, the cash generation is likely to fall quite significantly because of the way they’re changing the structure. So, it’s a complicated situation. We’ve been reviewing it. I can’t talk about what decisions we have or haven’t made in the last month or two, since that latest announcement, but with any company, we review the new information. We try to be incredibly objective. Part of our investment process is if the investment case changes, to revisit it very carefully and the investment case has changed. We weren’t expecting quite the scale of the changes that they’ve introduced. So, we have to review that very carefully and take a refreshed view, but unfortunately, I can’t talk about where we are today.
Why have discounts widened?
Gavin Lumsden:
We’re nearly out of time, maybe we’ll end on a couple of questions on the trust itself. Peter Lloyd says: ‘Merchants has avoided the dramatic widening of share price discounts to net asset value, which have affected many others, do you have a view why discounts have risen so much and why it hasn’t affected Merchants?’
Simon Gergel:
I think part of the reason for discounts rising, as we were discussing, is money coming out of the market and going elsewhere. So, there’s been a lot of selling pressure. Merchants has had a large private client investor-base, many of them are on the line today, listening today. They’ve generally been quite supportive and buying over time. That’s meant that if there have been one or two larger investors that wanted to sell out, those shares have generally been absorbed. In fact, we’ve been issuing new stock until very recently. So, I think by communicating with people, explaining what we’re doing, talking about the opportunities we see, talking about the potential we see in the portfolio, hopefully we can continue to have individual shareholders looking to buy into Merchants. Exactly what’s moving discounts in the wider market is a question I don’t think I can necessarily answer.
Gavin Lumsden:
An adjunct to that from another viewer, just wondering, does Merchants have a formal discount control policy?
Simon Gergel:
We don’t have a formal policy, but the directors do have the potential to buyback stock if the discount does get very wide.
We’ll have to leave it there, Simon, but thanks very much for answering all those questions. Thank you to you all for sending so many questions and sorry I couldn’t get through to all of them. That’s all we’ve got time for and I hope what you’ve heard today has whetted your appetite a bit for the UK stock market. In the meantime, that’s it from us. Do fill in your feedback forms before you sign off. Thanks again and happy investing!
