Thank you. Good morning, and good morning to all the shareholders and non-shareholders alike. Really delighted to be here. Actually, Allianz and our predecessor companies have been managers of the Merchants Trust really since its foundation 137 years ago. It was originally set up by somebody called Robert Benson, who became the Benson in Kleinwort Benson, which Allianz bought. But I'm delighted to speak here to talk to you today. And I'm going to describe what the Merchants Trust is, how we go about picking stocks, what's currently in the portfolio, a little bit about how we see life in the UK, in the UK equity market in particular, and then take hopefully lots of questions. So, without further ado, why don't we move to page four, please? And I'll give you an introduction to what Merchants Trust is. Just a couple more, please. Thank you. Brilliant.
So, Merchants Trust is an investment company that is trying to deliver an above-average level of income and income growth, together with long-term capital growth, through a policy of investing predominantly in large UK companies. We do have up to 10% of the portfolio outside of the UK. We have a dividend that has grown every single year for 44 years now, and we have a dividend yield of about 4.5% to 5%, and one of the highest yields in the sector. And that dividend record makes us one of the AIC Association of Investment Companies Dividend Heroes. We have a strong long-term performance record driven by active stock picking with high conviction and a very clear value approach, which I can explain later. We have one of the lowest management fees within the sector and a highly experienced independent board of directors who are there to look after shareholders, as they are for all investment trusts. The portfolio is highly liquid. Probably less relevant for this audience, but it's over a billion pounds in gross assets. And we have some gearing, about 12% gearing, which the idea behind gearing is to enhance returns in the long term, provided we can make a return above the cost of debt, which is about 5%. So we are confident long-term we can do better than the cost of debt.
If we move on to the next page, next couple of pages talk about philosophy. So, we've got a fairly simple investment philosophy. We're trying to buy companies that are materially undervalued in the stock market, and we hope that by doing that we will make a good return as those companies both grow and hopefully get revalued towards fair value. I think to do that effectively you need to have two things. One of which is I think you've got to be prepared to be opportunistic because good companies aren't generally cheap. You know, there are periods when there are, and when that happens you've got to be opportunistic and you've got to invest with conviction and take highly concentrated positions in good companies when you get those opportunities. And of course if you're going to do that you also need to think very carefully about risk. Risk at the individual company level and risk at the portfolio level.
So, when I talk about risk at the company level, we think about three types of risks. Operational risk, if something can go wrong in the business. Financial risk, if there's too much leverage, you can still, as an equity holder, you can still get diluted or lose money even if it's a fundamentally sound business if there's too much leverage and the company has to raise money at the wrong point in the cycle. And then the third type of risk is really valuation risk. If you buy a company that's too highly rated to start with and it gets devalued, there could be nothing wrong with the business, but you might still not make a very good return as an investor. And then at the portfolio level, we think about all the types of risks you'd expect us to consider, sector and diversification, different investment styles, different positions, but I think we also think about particularly how much money have we got in domestic stocks versus international stocks. The UK stock market is a very international market, well over half the earnings come from abroad, so the split within the portfolio is quite important. And we also think about things such as the mix between cyclical stocks and defensive stocks.
So, that's a very quick introduction there. And if you turn onto the next page, what do we, when we think about income, a few words to say here. So, you might think that investing for income, buying companies with good dividend yields, would give you worse returns because if companies are spending, giving more money back to shareholders, they're investing less in the business and they might grow less. The actual history of the last 25 years and actually many other periods is the opposite. The highest yielding quartile of stocks have given the best returns in the last, so far this century, which may sound counterintuitive, but of course when you're buying high yield shares, they're often high yield because the share price has come down. You're often buying companies cheaper than they have historically traded or cheaper than other companies trade. And it's a form of value investing.
Now, having said that, we do not ever buy a company just because of the yield. We look to buy companies with a decent yield, but we buy companies where we think we can make money. It's all about total return. So, once there's a share in the portfolio, there's no automatic sale if, for example, the share price goes up and the dividend yield drops below the market yield, or if in some cases if companies cut the dividends, we may still remain invested. So, the investment approach is really about making money, about absolute returns, but we fish in the pond of higher yielding shares.
If you move on to the next page, please, Avelina. When we look for a company, we look for three different things. Essentially, we want to buy sound businesses. So, we look at the business fundamentals. What is the company's competitive position? What's their raison d'être really? What is their financial position? What returns do they make? How strong are they financially? Who are the management team? What's their strategy? What's their capital allocation history? Really all the nuts and bolts you would expect us to understand when thinking about a company. What makes this a good business? The second thing is it's not enough to just have a good company. We want to have a company that's cheap, that's offering value. So, we think a lot particularly about the cash flow value. How much cash are we getting back? But also, we'll think about asset valuation. We'll think about other measures. So, we want to buy good companies that are cheap.
And then the third thing that we think about is what's the external environment? Because you can have a company that looks cheap, but if it's got some significant structural headwinds, structural themes that are negative, that could be a problem. These could be demographic changes, technology changes, those types of issues. Ideally, we'd like to have companies that are strong, cheap, and with positive structural themes, but sometimes we'll buy companies where there are negative themes, but we have to be really careful and continue to monitor those. So, that gives you an idea, and I'll give you an example in a second. So, if you can turn the next page. Just before I do that, just give you the overview of the process in total. So, we start with probably 350 companies we can look at, which is a combination of the high-yielding stocks in the UK plus a few overseas stocks that come from other members of our investment team. We're part of a very large organization at Allianz Global Investors. Many of my colleagues look at international stocks. In fact, one of the co-managers, Andrew Koshis, spends half his time looking at European dividend stocks as well.
Once we've got ideas, we'll then pass them through our investment process, look for fundamentals, structural themes, and the valuation, try and find the highest conviction ideas, and then we'll build a portfolio based on the conviction level, the risk of the different stocks, how they fit together in a portfolio, and particularly thinking about the downside risk on individual stocks. And then just as important as the buy discipline is the sell discipline. We will sell shares if we think they get fully valued, or particularly if you don't want to own companies when they're overvalued, but we're also very disciplined at reviewing companies where the investment case changes or even where we've just changed our view on the investment case where we may have got it wrong, and we will often sell or sometimes sell a share if we think we've got the investment case wrong or if something's changed. And then thirdly, there's very often better opportunities, and at the moment, there are so many opportunities we are having to sell companies we quite like to buy companies that we really like.
And together that ends up with a portfolio of 40 to 60 stocks. We are at the higher end now of that range. We have been at the lower end for quite a long time, but I think in the last year or so, we've found so many more new ideas, we've moved up towards the higher end of that range. So, if I give you one example now on the next page, Hikma Pharmaceuticals, some of you I'm sure will know this. Some of you may not. It's not one of the best known pharma stocks in the UK. But it operates in three different activities. If you think about the fundamentals, the largest one is they're a manufacturer of generic injectable products. Now, you think about generic drugs, you know, pills that have gone off patent but that are generally cheaper for the customer. In the area of injectables, these are highly complex typically products to make. They've got to be made in a very sterile environment because you're injecting these products straight into the bloodstream and the distribution of injectable products is also quite complicated. So, it's an area that makes very high returns, very high margins, and they've got a really good position and it's got good growth.
They do also have a more typical generic business. And then their third area is a really strong position in the Middle East in a lot of different countries where distributing and manufacturing drugs often under license for big companies. And they make again very good returns in that area because of their track record and their knowledge base there. It's a company with, as you can see, a lot of manufacturing plants. They spend a lot of money on R&D, a wide product range, and a really good growth record. So, it's a strong business with a good growth record. It benefits from some pretty powerful themes. We've got aging populations, also health care needs are growing dramatically, and that's particularly true in emerging markets like in the Middle East and North Africa. They also benefit from the particularly US position. They've got US manufacturing plants. We're seeing tariffs and other barriers going up in the US, which is giving them a favorable position.
So, it's a business that has some structural benefits. And the other thing of course is that health care budgets are under pressure and many authorities are looking to save money by going to generic products, and that plays into Hikma's strength as well. So, you might say, "Well, that's a great, got a strong business, good growth, attractive themes, why is it cheap?" And what's happened is there've been a few issues, particularly on the injectable side, where they tried to maintain margins at a very high level, and that compromised their growth opportunities. The chief executive has been changed, the management have been changed at the US division. They are now pushing much more aggressively to grow the business, accept a slightly lower margin, but still a very healthy margin in that area. But there have been a few profit warnings, which the stock market hates, as you probably know. And that has brought the shares back to a very low multiple, something like a single-digit price earnings ratio, a very significant discount to where it has traded in the past and where its peers are trading. And we think that, we thought that was a great opportunity when we bought into the shares. So, that's an example of a stock that we bought the first time in the last 12 months or so.
If we move on again, and I'll say a little bit about portfolio position, but really this slide we can come back to in questions because there's a lot of information here. But really, starting from right to left, what's quite unusual at the moment is we have nearly half the portfolio outside, or just over half in the FTSE 100 in the top 100 stocks, and about 4% internationally in large companies. But about 45% in medium-sized companies or small companies, that's quite unusual. That's about the most we've gone into medium and small companies. That's because we're finding tremendous value in that part of the market at the moment. If you look at the sector level, and again, we can come back to this in more detail under questions, where we have, we've actually got exposure in quite a large part of the market, quite a lot of different sectors. We're finding value in many different sectors because the market's quite polarized within sectors as well as across the overall market. But the areas where we're particularly strong compared to the benchmark are areas like real estate, construction, building materials, retail. So, some of the more domestic areas and which tend to be particularly out of favor at the moment because there's a negativity and negative sentiment about the UK market. And I'll come on to that in the outlook section. That's where we've got the biggest overweight positions or differences between us and the benchmark.
And then if you look at the individual stocks on the left, there are some very large companies at the very top of the portfolio, but you very soon get into medium and smaller size companies, where we have some really significant positions. Now some of those companies I'm sure you'll be very familiar with, but others you might be less familiar with depending on how closely you follow the market. So, if we move on to the next page, this is another way of thinking about some of those areas we have exposure to, where we're finding strong companies that we think are very cheap that fit our process. I said housing-related area we find a lot of opportunities. These are not just house builders, but companies making building products, producing building materials, distributing building materials, even DFS which supplies sofas that tend to be housing-related in that people often buy a new sofa when they move house. So, the strength of the housing market has some impact. And then some other things we've got companies that are exposed to industrial recovery like RS Group, XP Power, and we've got quite a few companies exposed to the commodity area and also the real estate where we think they would benefit as interest rates come through, benefits of lower interest rates come through over time. So, that's a very quick view and again we can come back to this in questioning. That's not the entire portfolio.
But if we move on again to the next page, just some of the acquisitions and sales in the last 12 months. It's been a pretty busy period. Turnover of 30% is a bit higher than we normally do. I'd say we're normally turning over the portfolio once every four, maybe four to five years. So, 25% turnover is up about 30%. It's been a bit higher and that's because we found so many new opportunities and there's been quite a lot of divergence of stock performance, which has meant we could sell some companies at quite value. We've had a few companies taken over and we found lots of new opportunities. Again, I won't go through this now, but if there are questions, I'm very happy to go into that in the Q&A.
So, if we move on to the next section, which is about dividends and performance. So, I said at the beginning the Merchants Trust has grown its dividend for 44 consecutive years. One of the great aspects of investment trusts, as many of you will know, is that the directors can squirrel away money in reserves, income in reserves in the good years to keep growing the dividend in the tougher years. And this has worked very well through the financial crisis and through the period of COVID. And if you've got sharp eyes, you'll see that during COVID, for example, in 2021, 2022, the directors had to use the reserves to keep growing the dividend every year. But since then and before then, we were able to put money into reserves because we didn't pay out the entire earnings of the company, the entire income, to shareholders in that year. The reserves at the end of last year were 20.3p. When I say last year, with the calendar year ends January, end of January, not the end of December. So, this January, the reserves were 20.3p, which is about 70% of a full year dividend. It's still considerable potential for future dividend growth even if there's an income disruption in the market.
So, the following page, as you can see, shows the total return, which is the other objective of the trust. The total return over this last decade or so has been around about 165 to 170% and that's considerably above the benchmark return. There is gearing in the trust, which has helped that return in that period when the returns have been so strong. And what we show at the bottom of the page is the returns over different periods for both the portfolio and the benchmark, which is the FTSE All-Share Index. It has been for the last 9 years. And you'll see that over the 10-year period, returns are roughly in line with that. We've been a bit behind that, particularly in the last two to three years. They've been quite difficult periods for our investment style. We found the market has been very polarized. Some of the areas we've been buying into like medium and small companies in the UK have been under pressure and have fallen to levels that we think are very cheap. But they've fallen further than we thought they would. And that has impacted our performance. But there have been other areas that have worked quite well. But in the last two or three years, we have underperformed and that means over 10 years, our performance is only in line with the benchmark. But it's still very strong at the NAV level given the gearing. It's also strong in peer group terms compared to our competitors. But we think there are exceptional opportunities in the market and I'll come onto that in a second. And so we are very confident we will be able to deliver good performance in the future.
If we move onto the next page, one interesting slide I put together for the annual general meeting this year because I've been running the trust for 20 years now, is that if you'd bought the shares back in 2006 at £4.51, you'd over the subsequent 20 years, your dividends alone would have got you back your entire investment and you'd still have shares worth over £6. This chart does not show the full total return because if you'd reinvested those dividends, particularly if you'd reinvested in the early part of the period with quite low prices, you'd have made really good return as well. So, the total return is higher than that. But you could have seen that you could have got had all your money back over 20 years and still retained your investment. And that's quite an interesting thing to note because one of the challenges for investors is to stay invested in something through thick and thin, particularly through the difficult times. But if you've got a steady income coming in and it's giving you, you know, paying off your investment over time, it sometimes gives people a comfort to ride through the tough times and take advantage of the recovery when they come. And as you probably know, when markets recover, it often happens very quickly from the worst points. So, if some people might say, you don't want to be invested in the market when it's going down, but the challenge is getting back in when it's going up and knowing when that happens. And it's very hard to time the market. What there is a well-known phrase, it's better, what really matters is the time in the market rather than trying to time it, rather than timing the market. If that makes sense.
So, if we move on, just one more slide on the structure, which is about the gearing. The trust has about 117 million of long-term borrowings, well, fixed borrowings. Some of them are short to sub-term and some of them are long-term. They go all the way out to 2052. So, this is money that is committed that we've borrowed. The average cost of debt is about 5%, 5.2%. It's come down from what was quite high 9 or 10 years ago at 8.5% and it's now quite reasonable. Gearing's 12% or so, in the range of 10 to 25%. The directors have set that range of where they're comfortable with gearing policy when they draw down on debt. As I said earlier, gearing can enhance the returns in the good years, but it does make the returns more volatile. And in down years, it will exacerbate the movement. It also helps increase the dividends we can pay to shareholders for technical reasons, which I can go into if there are questions.
So, if I say a little bit about the outlook now, because we have a large exposure to the UK equity market, and if you turn the page, please. And go on one more, sorry. We think the UK equity market offers an exceptional opportunity on a global basis, and I will try to explain why that is, and particularly the case in lots of medium-sized companies. We don't think the UK economy is out of line with what you're seeing in other countries elsewhere, other countries. But the narrative seems to be a lot more negative about the UK. We think the benefits from falling rates are yet to really come through, but the situation is not as bad as many people think it is. And although there have been outflows from the market, we are still, you know, we think a lot of those have been structural, but they now should be coming to an end. There's an opportunity if those outflows ever stop. And there are people buying the market very aggressively, particularly takeovers and buybacks. So, if we take each of those in turn, and we go on to the next page, please.
This is probably my most complicated slide, so I'll spend a minute or so explaining what it is. This looks at various major markets in the world, from the Nasdaq 100, S&P on the right-hand side in America, through to the FTSE 100 and the FTSE 250 mid-cap index in the UK. It looks at where those markets have traded on a price-to-earnings ratio, how much you pay for a pound or dollar of profit. So, if you take on the right-hand side, the Nasdaq 100, at the moment, the blue bar is about 22, 23 times. You're paying $22 for every dollar of profit. That's actually slightly below where the Nasdaq has traded typically, but it's well in the middle of the range. And that's quite a high level compared to other markets. The S&P 500, obviously the massive US market, that's trading above its long-term average about 20 times earnings. And most markets are actually trading above their long-term averages. When you get down to the FTSE 100 in the UK, it's trading at its average market valuation, roughly. And that valuation is much lower than most of the other major markets. And then what really stands out is the FTSE 250, which is trading in the lower quartile of where it's traded in the last 10 years. It's trading well below the valuation of the FTSE 100, which is very unusual. Because historically, medium-sized companies in the UK have grown faster and have been more highly rated than the large companies. So, it's a pretty exceptional time in the mid-cap area when you look at shares in terms of the earnings valuation or even the dividend yield, which is higher in the FTSE mid-cap than it is in the large-cap index.
If we turn to the next page, so our assertion is the UK economy doesn't look particularly out of line with those elsewhere. And if you look at the level of government debt, it is, sorry, the level of growth on the left-hand side, growth at 1% is clearly not strong, but it's actually better than much of Europe has been delivering in the last few years and Japan. And actually it's been revised up typically in the last two or three years, but it is lower than America or Canada. But it's not out of line with Europe. And then again, if you look at government debt, the UK does have quite a high level of government debt, 90 to 95% of GDP. But again, it's lower than, well, much lower than Japan and America, but it's also lower than France and Italy. Only Germany, which is one where you can't see the name, I'm afraid. Only Germany has a significantly lower level of government debt. So, when we look at the UK, we think that despite the pessimism, it's actually not a particularly bad outlook compared to other G7 countries.
If we turn the page again, the interest rates have now come down six times from where they peaked to now the 3.75%, so they've come down a long way. That has a certain benefit. The cost of a mortgage and housing affordability has come right down in the last three or four years. That's partly because interest rates have come down and mortgage costs have come down, but it's also because house prices have not moved when inflation and earnings have grown very significantly with the post-Ukraine war. So, the real value of housing has fallen, and the affordability of homes is back to roughly the long-term average. It's spiked up a little bit in the last couple of months because the Iran war has pushed up bond yields, but we're not far off long-term averages, which might be surprising given how depressed the housing market is. And also, if you look at how consumer indebtedness, households have quite a high level of savings. The level of debt has come down significantly in the last
15 years. And the level of debt in non-financial companies has also come down. So, there isn't, apart from the government sector, which is highly leveraged, there isn't actually that much leverage in the household sector or the company sector. So, we think the UK economy has potential to rebound if confidence, if and when confidence picks up.
On the next page, you'll see that there have been big outflows from the market. So, pension funds and insurance companies used to own half the market, and they've pretty much sold everything. They're down to 4 or 5% of the market. They were the structural sellers of the UK market and massive sellers in the last 30 or 40 years. They've pretty much gone. Most of the market is owned by foreigners who don't have to own the UK and they choose to, but they're not structural sellers. And so if there's any improvement in sentiment, if people want to buy the market, there's no real source of shares on a structural basis to supply that, and the share prices may well rally, potentially quite quickly.
On the right hand side, however, the retail investor, the individual person, has been selling shares quite aggressively in the last four years. I think the narrative in the UK has been particularly weak. And the narrative internationally, particularly in America, has been very strong, and I think that's taken the flows. But these flows can move very quickly and they are subject to sentiment. So any change in sentiment could lead to quite a dramatic change in the outlook.
And then finally on the next page, I think it's finally we've got who is buying the UK market. We are seeing a huge number of takeover bids in the UK market, some in the portfolio as well, from either private equity and often from competitor companies internationally who see the value in the UK. And we're also seeing an enormous level of buybacks. 50 to 60 billion pounds a year is being bought back by companies, which is equivalent to one and a half to 2% of the value of the entire market. So this really is a major buyer of the market. So again, if there's any change in sentiment, the market could really, because of these buyers, could do very well. And I think one of the reasons why the UK market has performed actually quite well in the last 18 months despite the really negative narrative is that there is this structural buying of the market from buybacks and takeovers, which is supporting it even if individuals are selling.
So that's really the summary. If I turn to the next page, before we get to questions, just to remind you what we're doing: we're trying to deliver a high and rising income stream and good total return. We're really excited about the opportunities we see in the market. We've delivered a very strong dividend track record over many, many years, many decades. We've got a strong long-term performance record driven by active, value-orientated portfolio management. And we've got other strong features of the trust like a low management fee and a strong independent board. And with that, I'll hand back to questions and be delighted to take your questions. Thank you.
