Interview with Simon Gergel from Merchants Trust

Good morning, mate. Hi. Good morning.

Thanks. Yes, good morning everybody and I'm delighted to do that. So, Merchants Trust, before I do that, I'm just going to say something very interesting about the UK equity market at the moment is there are a lot of, there's a lot of polarization in the market. We've seen large outflows of money from UK retail funds and that's put a lot of stress on the system and in particular it's led to the underperformance of medium-sized companies compared to large companies which have actually performed very well. So for the first time in about 20 years the medium-sized companies yield significantly more than the large size companies. I think that's something really notable and really unusual. So I thought I'd just start with that.

But yeah, getting into Merchants Trust specifically. Merchants is an investment trust that's been around for 135 years. It has a policy of investing predominantly in large cap UK equities and the objective is to deliver a high and rising income stream. Merchants is a dividend hero. It's raised the dividend every single year for 43 years. The current yield is just over 5%. And it's got a strong long-term performance track record from a high conviction, actively managed and value orientated portfolio. And the third thing to say at a high level is we have one of the lowest management fees in the sector, 0.35% of gross assets, and we have a very experienced board of independent directors who are there to represent shareholders as they are in any investment trust.

So just talking about the dividend track record, I mean one of the great features of investment trusts, you touched on it earlier, is that directors can put money away into reserves in good times to keep growing the dividend in tougher times. The directors of Merchants have used that ability very carefully and very sensibly over the last 43 years, putting money away, say, before the financial crisis, before the COVID pandemic, and then drawing on those reserves in the tougher years when income was under pressure to keep growing the dividend to shareholders. As we sit here today, the dividend reserves at the end of last January were 18.8p, something like 60% of last year's full dividend. So significant reserves for the future and the income outlook remains pretty solid in the portfolio. So we are hopeful we can continue that track record.

If we then move on to what we're trying to do, how we pick stocks. First thing to say is we are high yield investors. We're investing in high yielding companies. And some people think there might be a conflict between investing in high yield companies and the total return you can generate. Actually, surprisingly perhaps, the evidence is to the contrary. High yielding companies on average have delivered better returns compared to the market. This chart on the right hand side shows 25 years of data and you can see that the top quartile of companies in terms of yield has delivered the best return and significantly better return than the market overall over 25 years to the end of last year. Actually the top decile, which is the very top 10%, has not been quite as good as the top quartile. There are more value traps, companies with high yields that shouldn't necessarily be paying those or aren't necessarily such good value in the very highest yielders, but certainly overall both the top decile and the top quartile have been good places to be.

Now we don't just buy companies because of the yield. We buy companies where we think we can make money. We think about total return we can generate, but we fish in that pond of higher yielding shares which means that overall Merchants Trust has a very high yield compared to the benchmark. But the individual shares are chosen for total return considerations and we wouldn't, for example, sell a share necessarily. If the share price goes up and the yield drops below the market, there's no automatic sale. We look at it very much on the total return we think we can get looking forwards.

So having said that, just move on to a couple of slides about current outlook and how we're positioned. And I'm very happy to take questions about how we actually pick stocks as well. I think if you look at the UK market, it's interesting, the last 40 or 50 years you've seen a structural outflow from pension funds and insurance companies. So the chart on the left shows in the light blue color domestic insurance companies and pension funds. And when I started my career in the late 80s and the early 90s, they owned half the market in the UK. They now own about four and a half percent of the equity market. They've moved to bonds. They've moved out of the UK internationally. Most of the market today is owned by foreign investors, often through tracker funds or sometimes through active funds. But they don't have to own the UK. They own the UK because they want to. They're not structural sellers. That structural selling from institutions we think has largely gone away.

Now we are seeing, however, a lot of selling. I have been seeing a lot of selling from retail investors, retail funds. That is more discretionary, that can change quite quickly as sentiment changes. So far it's been negative, but if that were to turn at all, given the institutions have stopped selling structurally, the market could get a lot of support.

Then there's, if you look at the valuation of the market, why should it get support? Well, the UK is one of the cheapest markets. I'm sorry, the chart here is probably quite hard to read on the left hand side. It looks at the cyclically adjusted price earnings ratio, which is how much are you paying compared to the last 10 years of earnings of a UK company on average. And that ratio is about 13, 13, 14, and that's significantly lower than other western markets and lower than, say, the very long-term history of the United States, which is shown in the dotted line, and way below where the US is. And really the only markets that are cheaper than the UK are countries like Eastern European countries, emerging markets, China, Brazil. So we would argue that the UK is one of the cheapest developed markets out there.

And also if you compare the US-UK valuation to the world on a sector adjusted basis, which makes adjustments for the sectors in the UK stock market, again the UK stands out on the right hand side as being very cheap compared to its history. So it's an interesting market to look at, we think.

And then clearly the main issue in the UK at the moment, I think, is that sentiment is quite depressed. There's a view that the UK economy is somehow in a very difficult position and the chancellor has a very challenging budget coming up in two weeks time, which she does admittedly. But actually the UK's problems in context are not that bad. The government deficit in the UK is somewhere in the middle of the pack of the G7. It's certainly not as bad as France or the US. The actual level of government debt as a percentage of GDP is actually lower than most of the G7, with the clear exception of Germany. And the private sector is not particularly indebted either compared to its history. And on top of that, GDP growth, the growth of the economy, has been reasonably resilient given the tough background and the tough confidence background out there.

So I think there are reasons to think that if the chancellor can reassure markets in a couple of weeks time, the underlying situation in the UK is not out of line with other markets. And I think there are potentially some buyers. Well, I'll come on to that in a second.

Just coming back to what I was saying about the composition of the market. Within the market, the larger companies have been outperforming. Larger companies tend to be a bit more international, includes sectors like aerospace and defense and energy, but also banks which have been a very strong performer with very strong earnings momentum. And so large companies have outperformed both medium and smaller companies, which is unusual. More unusual still is the valuation gap where large companies now are significantly more expensive both on a yield and price to profits effectively valuation compared to the midcap 250 index. That's unusual because medium-sized companies tend to deliver higher growth over time and certainly have done historically. So it's unusual to be able to buy those companies cheaper.

I think we are not the only people to have noticed this. There are other people buying UK companies. In the first case, you've got a lot of takeovers going on, both by corporates buying UK businesses but also from private equity companies coming in. We've seen a large number and large value of takeovers coming in the market. And also we're seeing a very high number of buybacks, about 2% per annum of the stock market is being bought back by companies themselves at the moment, which makes a lot of sense given how cheap the market is and has been and how much cash generation many companies have got.

So there are two buyers, whether you know of both M&A and companies themselves, and so if there's a change of sentiment the market could rally quite hard. And in fact, you know, the market has actually been pretty strong in the last year or so. The Footsie is very close to 10,000 and that probably reflects to some extent these buyers coming in to the market.

Sorry, I pressed the wrong button. So that's really my presentation, Matt, and happy to go into questions. There are appendices if we need them.

Yes. It's worth saying we don't necessarily start by saying, you know, do we want to be in the Footsie 100 or midcap? We look for where we find opportunities and we found a lot of opportunities in that midcap part of the market and that's prompted us to put more capital to work in that area. Merchants' strategy is to be predominantly large cap. So we will never go, we don't intend to go below 50% in Footsie and a few international large cap stocks as well. But we are about 45% now outside of those very big companies. So that's about as far as we've been, certainly in the history that I've been involved in.

Yeah, it's a really good question. So the income coming into the portfolio, the dividend growth of the companies has been a little bit subdued in the last two or three years as companies have stepped up their buybacks. I think we're perhaps getting towards a turning point. I mean, I think we're at a very interesting juncture. We need to see what happens. But companies have bought back shares, as they've done that they've built up a buffer which means that the cost of the dividend overall might have been going down as they've reduced the share count, which should allow companies to increase their dividend per share. And also because they're doing buybacks on top of dividends, if there's any pressure the buybacks will be cut first probably rather than the dividends.

The dividends should be pretty well underpinned. The payout ratio has come down a long way. I think we're at an interesting juncture though because as we move forward share prices have rerated, particularly in sectors like banks and perhaps energy, and whether companies decide to change the mix of buybacks back to special dividends or ordinary dividends again will be interesting to see.

Perhaps a bellwether in this is Next plc, which has for a long time had a really clear strategy where if the share price is below a certain level they will buy back shares and if it's above a certain level they will use surplus capital to do special dividends. They've just moved back to doing special dividends and it will be interesting to see if other companies follow that by pushing dividends up a bit more now that they've built this buffer and their cash flows have improved and the payout ratio has gone down. So I think we'll have to see what happens in the next quarter. We certainly, when we engage with businesses, are saying we absolutely see the benefit of buying back shares when your shares are cheap and trading well below fair value. But if they're approaching fair value or perhaps even fully valued, we would urge you to do a bit more in terms of dividends generally.

I think the biggest problem at the moment is uncertainty. So I think the market has been waiting a long time. Investors have been waiting and consumers and corporates have been waiting a long time to know, to see what's in the budget. There's been a lot of kite flying of potential policies and that uncertainty is damaging. I think getting the budget finally out the way and a decision will be really helpful.

I think markets would prefer something fairly straightforward that's not inflationary like an income tax increase, but if that's been ruled out, hopefully she can find other measures to raise the money and perhaps keep a lid on spending that will appease the bond market. As I said earlier, the UK does not have a significant problem compared to other western markets, but there is a perception problem. So I think it's a delicate balancing act. I think the most important thing will be getting the uncertainty out the way. There may well be one or two implications for different sectors or different industries from what actually comes out in the budget.

I think the other thing we need to keep an eye on is what it means for, as you say, for bond yields and whether the Bank of England can keep cutting interest rates. And I think up until yesterday it was looking very likely there'd be an interest rate cut in December. I think we'll have to see what comes out of the budget. But I think the direction of travel of lower rates over time is still intact.

Yeah. The word creative, let's say we use the opportunities that the investment trust structure gives you. So we employ gearing, the board employs gearing. There's about 13% gearing at the moment and the range of the board's policy is 10 to 25% at time of drawing down debt. That gearing not only should enhance the total return provided the returns we make on the portfolio are above the cost of debt which is about 5.2%, but also it enhances the income that we can pay out because some of the cost of the debt is charged to capital account. So that means that the revenue account benefits more than you might expect from the extra gearing and that enhances the income we can pay out.

And the second thing as you say is covered call overwriting. We do a modest amount of covered call overwriting on shares that we would be willing to sell at the strike price or parts of shares we would be willing to sell. So typically we'll say if we're willing to sell half a percent of this position at 10% above our current price in the next three months, we'll give somebody the option, we get paid the option, the trust will get paid the option and that becomes income that can then be distributed. So we do do a modest amount. Last year that contributed around about a million pounds I think, might be slightly less, out of maybe 40 odd million, 45 million, I can't remember the exact number of income. So it's about 2% of the income we generate is from covered call overwriting.

It actually works best in markets that are flat or downwards. In an upward market you give away a little bit of the upside potentially from writing call options. On the other hand with gearing you are offsetting that to some extent as well. So I think it's a very sensible strategy for a trust with long-term capital that has highly liquid UK stocks.

Yes, we tend not to go above three or four months.

That's all. Absolutely. I mean we have a residual cash balance for working purposes, one or two percent, but effectively we are fully invested and with gearing, you know, more than 100% effectively invested.

It's actually very similar to the yield we're paying out. It's about 5.2%. And so off that income comes things like the cost of running the company and cost of debt. But on the other hand, because of the gearing structure and because of call overwriting and so on, that actually boosted it back up to roughly the same as the underlying yield on the portfolio.

We have three long-term debt securities. The average cost is 5.2%. One is maturing in 2029, so about four years. One's about 15 years that was taken out fairly recently and one is about 29 years which was taken out five years ago. That one is a very low cost, that's about 3%. But the average cost, as I say, is 5.2. We did have a revolving credit facility about a year ago, but that was refinanced with a medium-term debt.

Yeah, it's a really, really good question. And as a value investor, you will occasionally get them. So to us, a value trap is a company where it looks cheap because you think that the fundamental value is above the share price or the share price is below the fundamental value. But over time that fundamental value is declining and that gap never really closes and the share price goes down as well.

When we look at stocks, we look at three things. First is what we might call the fundamentals and I think this is what everyone would expect us to understand, the competitive position of the company, the strength of the balance sheet, the financial profile, the management quality, all management strategy, all of those sort of nuts and bolts. We look at the valuation, we want to buy good companies or sound companies when they're cheap and we're very valuation conscious.

But the third thing we look at, we call it themes, which is really the external drivers of the industry that affect that business. And these are, the most important ones are long-term themes. So structural changes which could be demographics or digitalization or technology changes. We need to understand those external themes that are driving the businesses and ideally it's good to have positive themes. So demographic changes that support the investment case. Sometimes there are negative themes and particularly with value traps you can have negative themes which erode value slowly over time.

So if there's a negative theme, we work very hard to understand that theme and to make sure that it's fully priced in and to keep revisiting it. And a lot of our discussions actually around the desk are about these structural challenges where there are some, and sometimes they emerge and you weren't aware of them. So, you know, there'll be things that come through that we didn't forecast. But I think a good way of avoiding value traps is always to be alert to the possibility you got it wrong and we will get some things wrong. But also to keep thinking about those structural challenges and those sometimes cyclical challenges to companies that can mean that your fundamental investment case is actually challenged.

Yeah, it's an interesting industry because the consensus was two or three years ago that we were at peak oil demand and it was going to decline and then gas would follow. And I think ultimately oil demand will at some point peak and decline. There's not much sign of it yet. And gas demand probably quite a bit further out because gas is a transition fuel to some extent. There's lower carbon emissions from gas than coal say, and particularly also than oil. So I think you can see a decline in the medium to very long term for the hydrocarbons.

But the companies are managing with that very much in mind and are managing very tight capital disciplines these days. So companies like Shell and BP are being very prudent I think in the way they invest, trying to standardize processes, trying to and delivering enormous efficiencies and very strong cash flow. So Shell for example believe they can grow their cash flow per share by double digits till the end of the decade and the per share focus is something we've pushed Shell to focus on for many years and we're very pleased that they've adopted this in the last couple of years as a key focus of business. So they are generating cash, they're buying back equity and they're able to grow the cash flow per share.

So yes, there are structural challenges long term. We can debate how quickly that's going to happen. But on a per share basis, this business is actually delivering quite strong growth. We also have some opportunities amongst smaller oil and gas companies. So Harbour is a really interesting one that has emerged as quite a large company in the last two years through some corporate activity, particularly Energean, which is a big gas producer off the coast of Israel in the Mediterranean in particular. That's the biggest asset. Those are also interesting companies that have really strong cash generation.

Yeah, I mean we've got a lot of exposure to financials but it's very diversified. So we have reinsurance companies which is a very different cycle than many others. We've got companies like M&G Group and IG Group which are more in the financial trading and investing side. But we have some of the banks. We have a couple of the large banks. And they are, let's say, they benefit more from medium to high interest rates. They don't want really high interest rates because that was a challenge on the economy and their end customers. But they do benefit from interest rates staying higher. But we have other stocks in the portfolio that benefit more from interest rates coming down. So I think there's a bit of a balance there with the banks.

But it's not all about higher interest rates. I mean the big banks like Barclays and Lloyds have a big benefit still to come through from what they call the structural hedge, which is if you imagine they get a lot of cash sitting in deposits. They lend some of that out in the long term, they put some of that out for the very long term into the bond markets. Much of the money they lent out three or four years ago on virtually zero or very low interest rates is coming back and they can relend at much higher rates. So for the next two or three years at least the net income they can generate from those assets is significantly higher and that's giving them a tailwind as we go through that.

On top of that the banks are highly regulated today, much tighter regulation than they had pre the financial crisis, much stronger balance sheets, less leverage, and the bad debt experience at the moment seems to be fairly benign. So the banks are in a good position at the moment with strong cash flow, strong cash generation, high cash returns to shareholders. That won't last forever, but in the short to medium term they look like they're in a good position. And the valuations, although they've come up a long way or very long way in some cases and they've been really strong performers, they are still not necessarily expensive on a long-term basis. I think the banks were just very cheap two or three years ago. So we still have quite big positions in Lloyds and Barclays in particular amongst the large ones.