- St James’s Place faces a short-term revenue and profit drop, says Gergel
- Politically boring UK is good for investors
- Mid-cap valuations look especially attractive
Many investors will be familiar with the concept of sunk-cost fallacy, holding on to an asset because of how much money you invested in it in the past, not because of how well you believe it is going to perform in the future. Private investors and professional fund managers alike need a rigorous approach if they want to steer clear of this common mistake.
Simon Gergel, portfolio manager of the Merchants Trust, sold the trust’s holding in wealth manager and adviser St James’s Place (STJ) in November to avoid holding on to it for the wrong reasons. “Rather than creating a new investment case to justify an existing holding, we would rather step back, sell it and consider it again in the future,” he says.
Gergel runs a UK income portfolio of roughly 50 stocks, looking for companies with strong fundamentals trading at a lower value than the team thinks they are worth. The trust has underperformed over the past year, but as the table below shows, it has a very solid long-term track record in the medium and long term, comfortably ahead of its benchmark, the FTSE All-Share, as well as of many peers. It is one of the Association of Investment Companies’ ‘dividend heroes’ with 41 years of consecutive dividend increases.
| Merchants had a tough year but is the top performer on a three-year basis | ||||
|---|---|---|---|---|
| Sterling share price total return to 26 January (%) | ||||
| 1-year | 3-year | 5-year | 10-year | |
| Merchants Trust | -3.5 | 41.4 | 51.3 | 83.1 |
| Edinburgh Investment Trust | 4.7 | 40.5 | 35.5 | 75.2 |
| Temple Bar | 2 | 39.3 | 16.4 | 39.7 |
| Law Debenture | 0.2 | 36.6 | 69.3 | 115.7 |
| City of London Investment Trust | -1.2 | 26.4 | 31.5 | 67.4 |
| FTSE All-Share | 2 | 23.5 | 33.1 | 67.9 |
| Murray Income Trust | 2.7 | 14.5 | 37.7 | 71.1 |
| Finsbury Growth & Income Trust | 0 | 5 | 23.1 | 102.2 |
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Trusts in the AIC UK Equity Income sector with more than £500mn in assets. Source: FE. |
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St James’s Place accounted for 2.2 per cent of the trust’s portfolio as of 31 July 2023 and was one of its main underperformers in the previous six months. In the year to 26 January 2024, the company’s shares fell some 42 per cent as it grappled with regulatory pressure to change its fee structure following the introduction of the Financial Conduct Authority’s consumer duty rules. A first tweak to the fees sent the shares tumbling in July, and then the company announced further changes in October, including the removal of most of its exit fees.
The fee overhaul is relatively complex and includes the scrapping of exit fees on the “vast majority” of new investment bonds and pensions as well as a “rebalance” of its fee structure, resulting in lower overall ongoing charges for existing clients.
However, Gergel says he expects SJP’s revenues and profits to come down quite sharply when the changes come into effect in the second half of 2025, and then grow quickly again. In the long term, he thinks the business will still do well, but believes the situation is uncertain in the short term. There is the risk that further regulatory changes may be required, or that the new fee structure encounters implementation challenges, given that the company will need to adapt its software and systems.
Considering all this, the team has reviewed its position in the shares. “We said: our original investment case has changed. Do we still have a positive investment case today? Would we buy the shares with what we know today? We took the view that actually we might not, and we need to be disciplined, so we sold it… It doesn’t mean we’re negative on the company, just that we don’t have sufficient confidence today in an investment case to retain it,” he says.
This is one of the criteria that leads the investment team to sell a company, with other recent bets that didn’t work out including Vodafone (VOD) and emerging market manager Ashmore (ASHM). The managers also sell companies that have been doing well when they reach a target price, such as BAE Systems (BA.).
The trust sold BAE in April 2023 after owning it for a number of years. “The company has done a great job of improving its operational capability and its delivery. Profits have performed well, cash flow has been good and it has benefited from increased defence spending and the hope that it is going to accelerate. The shares significantly rerated, and we just thought it was fully valued,” Gergel says.
Recent additions to the portfolio include Spanish airports company Aena (ES:AENA), a rare example of the trust investing outside of the UK, and Assura (AGR), a developer and owner of healthcare property. Assura’s share price has struggled due to the impact that interest rates have had on property assets, which provided the trust with an opportunity to buy into the company at a price below its asset value in December.
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Merchants’ top 10 holdings as of 31 December 2023 |
|
|---|---|
| Holding | Weighting (%) |
| GSK | 4.6 |
| Shell | 4.1 |
| British American Tobacco | 3.5 |
| Scottish & Southern Energy | 3.2 |
| BP | 3.2 |
| IG Group | 3.1 |
| DCC | 3 |
| Barclays | 2.9 |
| Inchcape | 2.9 |
| Rio Tinto | 2.8 |
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Source: trust factsheet |
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More growth, please
Perhaps unsurprisingly for a manager who deals in domestic stocks, Gergel is broadly optimistic about the UK. But he does lament a “disconnect” between the stock market and the economy.
“There’s actually a lot of innovation in the UK economy. The UK is probably the world leader in financial innovation and fintech, for example. Meanwhile, the UK stock market is very global, the vast majority of sales and profits come from businesses around the world,” he says. “How does the UK stock market access the innovation going on in the UK economy? That’s a big issue that is not going to be solved overnight.”
Having more growth companies in the UK market “would be nice”, Gergel says. But he adds that, given the domestic market is home to more mature businesses, it makes sense that the focus is on returning cash to shareholders through dividends and buybacks. “In industries such as energy and food retail, you don’t really want these companies investing huge amounts in capacity, because that has been a recipe for disaster in the past,” he says.
Still, Gergel argues that the UK market is currently full of opportunities, partly because the UK looks “surprisingly boring” politically, after a few turbulent years. Keir Starmer and Rishi Sunak are “not a million miles away politically”, and the reaction to the Liz Truss mini-Budget in 2022 made it clear that “the markets are in control, and that there’s limited room for governments to do what they want on taxation or spending”, he suggests.
“There is almost certainly less political risk in the UK than in the US, and probably less than in most of Europe too,” he notes. He says economic performance looks in line with the rest of the world and valuations are cheap, all of which should in theory contribute to the attractiveness of the market.
UK managers have been saying that the market looks cheap for a long time, but attracting investors back won’t necessarily be an easy feat. However, hopes that the rate cut cycle will begin some time later in the year certainly make the 2024 outlook look brighter.
Among the sectors that look promising, Gergel flags reinsurance, which he says is seeing strong pricing growth after a few difficult years. The trust invested in reinsurer Lancashire Holdings (LRE) in the first half of 2023. Gergel is also finding fertile ground for opportunities in the mid-cap space, which he maintains look “unusually cheap”. “There has been full selling by some fund managers, even of companies that they like, because they have had outflows. It’s not quite the same for large caps, which tend to have a bigger global audience,” he explains. The trust had a 38 per cent allocation to FTSE 250 stocks at the end of December, with 54 per cent in the FTSE 100.
Gergel attributes the bulk of the last year’s underperformance to a style bias that results in the portfolio being more exposed to cyclical businesses and mid caps, which sold off as interest rates increased. St James’s Place was also a detractor, and there were no takeover bids for any of the companies in the portfolio, as the higher cost of debt created a more challenging environment for acquisitions.
“Because we have a value bias, we tend to be impacted if cheaper shares get cheaper. But then you often get a swing back when valuations start to recover, and they converge again. At the moment, the valuation dispersion in the UK is really high”, Gergel says.
Tobacco’s slow decline
One sector that stands out in the Merchants portfolio is tobacco. The trust had 3.5 per cent in British American Tobacco (BATS) as of November and 2.8 per cent in Imperial Brands (IMB), both well above benchmark levels. Gergel says that the sector ticks two of the three boxes that the trust’s managers normally look for in companies: fundamentals are strong and valuations are “incredibly depressed”. However, the backdrop is not favourable, with a reduction in smoking among the population that might be accelerating as well as increased regulatory action on non-tobacco alternatives.
Gergel thinks the market’s pessimism on these companies has been overdone. “While there are fewer people smoking each year, the pricing has offset that up to now in terms of revenues and profitability. Profits and earnings have grown pretty consistently over time. But that won’t carry on forever,” he recognises.
He points out that the two companies also operate in emerging markets, where the sector’s outlook looks brighter, and that vaping products still have potential. “I think it’s a very slow decline, but it is a decline and there is a risk it accelerates… But also there’s an opportunity there to buy strong businesses at extremely cheap valuations,” he concludes.
