THE MERCHANTS TRUST PLC
Half-Yearly Financial Report
For the six months ended 31 July 2022
Interim management report
I begin this half-year update with a reflection on the death of Her Majesty Queen Elizabeth II on 8 September. All of us at The Merchants Trust, would like to pay our respects and offer our condolences to all members of the royal family. The Queen's unparalleled reign of 70 years commands respect and admiration from around the world. She was a charismatic and respected figure on the world stage and throughout that time witnessed many changes on a personal, national, and global level. To put that in context, she was monarch for over half of the 133-year life of Merchants.
Regretfully the terrible conflict stemming from Russia's invasion of Ukraine is still raging. The conflict passed a six-month landmark at the time of writing this report. Some days there may be less in the news, but that does not diminish the scale of what is occurring and our thoughts remain with those affected. We can only hope that peace may return to the region in the coming months.
As I have written in previous reports the Russian invasion of Ukraine was a shock to the global economic system. It exacerbated inflationary pressures across the world, primarily of energy supply constraints, economic sanctions against Russia and the disruption of certain crop supplies from Ukraine.
To some degree the world has also been caught somewhat off guard with the foundations for a higher inflationary environment quietly cementing in the background over many years. Portfolio manager Simon Gergel describes this issue in more detail in his Investment Manager's Review.
Central banks are now acting more decisively and consistently in their efforts to control inflation, pushing interest rates higher. This is creating an environment in contrast to that of recent decades, where quantitative easing by central banks around the world led to a loose money environment where growth stocks flourished. We now have a very different new world, where both equity and bond markets have been weak and investors are showing nervousness. However, indiscriminate pressure on all stock prices resulting from macroeconomic concerns, largely irrespective of company fundamentals, can provide an environment where active management should prevail and for skilled stock pickers numerous opportunities can arise. Many stock prices have become depressed below the fundamental worth of a company. As shareholders will know, the opportunity to purchase good companies with sound prospects that are trading below their intrinsic worth is at the very heart of the Merchants investment process.
Against this difficult backdrop over the reporting period, we are able to report a marginally positive performance with a NAV total return (with debt at fair value) of 1.3%. That was ahead of the benchmark index, which returned -0.1%.
The UK market – value investing in vogue
The UK market has been a relative bright spot amongst global peers. The market includes a greater proportion of value stocks compared to growth stocks when viewed in a global context. The general move by investors spurred by rising inflation and interest rates, has impacted many of the largest global markets such as the US where high growth stocks predominate and in return favoured the UK market. In sector terms the UK market also has a relatively high exposure to energy firms that also benefited from the energy crisis unfolding across Europe.
It hasn't been a totally easy ride for the whole UK market though. Returns have seen a wide dispersion by sector and market capitalisation. Whilst the largest (mainly multinational) companies in the index provided good returns, the picture was worse for smaller capitalisation companies with greater exposure to the UK economy. Defensive companies perhaps unsurprisingly were better performers than more cyclical stocks which were shunned by investors concerned about the economic backdrop.
The UK as an investment
Whilst the UK has become more attractive over recent months and, indeed, we have seen overseas investor interest including takeover offers, in terms of an asset class the UK remained on a somewhat shaky footing with money flowing out of many subsectors, most notably from domestically focused small cap funds. UK equity income was more neutral and broadly flat as investors continued to find an income stream attractive amid the uncertain environment. It has been pleasing therefore to see Merchants continue to perform well with steady, positive investor demand.
Market demand and Issuance
Merchants' consistent strategy and strong long-term results have led to sustained demand amongst investors. As a result, for much of the review period Merchants traded at a small premium to Net Asset Value, allowing the issuance of new shares. Over the period under review, we issued some 7,220,000 shares for an aggregate value of £40.8m. Shares are always issued at a premium to the prevailing Net Asset Value, to make the process accretive to existing shareholders. All shareholders also benefit from issuance and increased scale with the company's fixed costs spread over a wider base.
Earnings
We reported this time last year, and again in the latest annual report earlier this year, that we have seen improving earnings following the lows of the pandemic. The period under review has followed a similar trend and earnings per share (EPS) for the six months under review reached 16.0p (2021: 13.3p) which is approaching the pre-pandemic level of 16.1p for the equivalent period in 2019 (2020 financial year). Our investment manager remains cautious on corporate earnings for the near future given the considerable economic uncertainties and rising costs for businesses. Even those businesses that can, over time, largely pass on cost increases to their customers due to inherent pricing power in their business are likely to see margin pressure in the short term.
As many businesses took the opportunity to cut or rebase dividends lower during the pandemic, it is pleasing to be getting close in earnings terms to the situation prior to that period, and recent trends have been favourable. It remains however hard to make predictions in the short term.
Dividends
As shareholders and followers of our process will know, we have a key focus on paying a high and rising dividend. This is important for many reasons. From a shareholder's perspective we recognise that a steady income is an important part of many people's investment strategy. Even for investors who are still in an accumulation phase an income-based strategy can still provide benefits – the compounding effects of reinvesting that income into more shares, themselves due future dividends, is extremely powerful. Dividends are only ever a positive element of investment returns and in the UK market they have become an increasingly important element of investment returns. In a rising market they will enhance the capital return from rising share prices and in a falling market they will help to offset the effects of share price falls. We also view dividend policies in mature companies as an important indicator of the quality of a company. The discipline to return funds to shareholders either by dividend payments or via share buybacks is an important aspect of good capital management where high levels of capital expenditure, R&D or reinvestment in the business are not necessary or prudent.
With the final dividend of the 2022 financial year being approved by shareholders at the AGM, Merchants has raised its dividend for 40 consecutive years – a significant landmark and one which the current board is proud to have played a part in over time.
The board has declared a second quarterly dividend for the current financial year of 6.85p per ordinary share, payable on 10 November 2022 to shareholders on the register at close of business on 7 October 2022. A Dividend Reinvestment Plan ('DRIP') is available for this dividend for which the relevant Election Date is 21 October 2022 and the ex-dividend date is 6 October 2022. This means that for the first half of the 2023 financial year, the aggregated dividend will be 13.7p compared with 13.6p for the same period last year.
ESG Stewardship
Our oversight of the ESG features of Merchants' portfolio has evolved during first half. AllianzGI uses an Integrated ESG process in stock selection, monitoring, engagement with investee companies and voting on resolutions. The board receives a regular report on the ESG rating of Merchants' portfolio including risk assessments, high/low rankings of individual positions, interaction with specific organisations and a carbon emissions analysis. This report uses data from MSCI along with AllianzGI's insight and proprietary tools. During the last six months, the board has reviewed several companies with our portfolio managers by considering potential return characteristics with issues such as transition strategies to net zero carbon, elimination of child labour in the supply chain and independence of the investee company board. We expect to develop our stewardship in the coming years and set out further disclosures in future reports.
Overseas investments
Our manager's use of the ability to invest up to 10% of the portfolio in overseas assets continued through the period and, at the end of the period, these holdings represented an aggregate 5%. The primary function of this ability continues to be to diversify sources of income in the portfolio as well as accessing some types of investment which are difficult to access through the UK market.
Shareholder contact
After two full pandemic-constrained years, it was a pleasure to once again be able to host an in-person Annual General Meeting for Shareholders in May. On a personal note, as it was my first physical AGM as Chair of the Merchants board, it was particularly enjoyable to be able to meet and chat with those shareholders who attended.
We spend considerable effort to ensure that our reporting is informative and interesting for shareholders. It was a pleasure therefore to take the 'Best Report and Accounts, Generalist' award at the Association of Investment Companies' annual awards earlier in the year, having also received this accolade in the 2021 and 2020 awards.
Outlook
What the near future will bring is extremely hard to predict. We can only hope that it is a world with less conflict and geopolitical tension. From an economic perspective there are many factors at play and the possible outcomes range anywhere from a moderation of inflation and return to more 'normal' scenario, to a full-blown recession and spiralling inflation. The UK market seems at the moment to be concerned with something akin to the latter scenario.
As shareholders of The Merchants Trust, you are accessing the active management capabilities and expertise of our investment manager combined with the oversight of the board. It is in times such as these that active management of an investment portfolio becomes particularly important with many divergences in performance between sectors and even individual companies. The ability of our manager to make the right selection of markets, sectors and shares can add considerably to long term shareholder returns. The investment management team continue to make changes to the portfolio where according to their judgement the prevailing outlook alters the investment case for portfolio holdings. As outlined in my comments and described in more detail by our investment manager in his report, the backdrop of uncertainty and associated nervousness of market participants makes for an environment of increased opportunity where shares become more significantly mispriced compared to their intrinsic worth. Happily this is the hunting ground for our investment manager who is looking to exploit those opportunities on behalf of our shareholders, delivering Merchants' objectives by purchasing new long term investment opportunities.