Interim management report
Economies, markets & Merchants’ performance
Shareholders will recall that in the Full Year report to 31 January 2023 I was able to reflect on a period in 2022 where Merchants had thrived due to the prospect of rising inflation and interest rates and a corresponding decline in the share prices of highly rated ‘growth’ shares. Throughout that period, Merchants’ portfolio of shares of good businesses bought at reasonable valuations had performed extremely well.
The first half of this year has been more difficult. As anticipated, central banks around the world employed aggressive interest rate hikes to cool rising inflation. In the UK, the Bank of England raised rates four times and by a total of 1.5% (from 3.5% to 5%) during the reporting period, with a further quarter-percent rise after the period end in August. Towards mid-year there were undoubtedly signs of some inflationary pressures subsiding but core inflation (which discounts volatile energy and food prices) had remained stubbornly high. The core inflation rate in the UK was 6.9% in July, up from 6.2% in February, whilst during the same period the headline inflation rate fell from 10.4% to 6.8%. These higher than expected levels of inflation have kept central bank rhetoric on the side of potential further rises, even if they are equally mindful of not driving the economy into recession.
The UK stock market is also affected by global equity market trends. After a fall from grace for technology and other high growth shares during 2022 due to the high inflation and rising rates backdrop, there has been a sharp reversal in the first half of 2023, with a rally in technology shares, particularly the largest ‘mega-caps’ that dominate the US market. This has supported higher growth stocks more broadly, rather than more value oriented companies. The early part of the year also saw a stark reminder of the risks in the banking sector when Silicon Valley Bank in the US found itself with a mismatch between bond assets it had invested heavily in and its obligations to provide liquidity to depositors. Investors were also unsettled shortly thereafter when Credit Suisse was forced by regulators into a rescue takeover by UBS. UK regulated banks have had stronger capitalisation requirements since 2008 and so this kind of scenario has been less of a concern domestically.
These conditions were not ideal for our investment manager and his value investing style. A relatively flat total return for the UK equity market masked the return of the dispersion between outperforming growth stocks and underperforming value stocks and Merchants’ Net Asset Value (NAV) total return was -2.2%, compared to the benchmark’s return of +0.8%. Our portfolio manager Simon Gergel describes the drivers of this underperformance in more detail within his Investment Manager’s Review. Merchants’ long-term record however remains strong and we believe that long term performance is the best continuing validation of Merchants’ consistent strategy of providing a high and rising income, together with long-term growth in capital for our shareholders.
Despite an overall flat performance of the UK equity market the corporate sector has performed well and improving cash generation has continued to support the ongoing recovery in dividend income for the trust. This has given the board confidence to raise the dividend for shareholders and to do so at a higher rate than had been possible since the start of the pandemic. Last year the first half year dividends increased by 0.7% and this year the increase is 3.6%.
Image of the UK remains an issue
For a long time there have seemed to be reasons for investors to avoid the UK equity market. ‘Old economy’ stocks, Brexit, pandemic uncertainty, political turmoil and, latterly, concerns over the UK’s domestic inflation and interest rate environment are a few of the reasons mentioned.
However, the UK equity market is not the same as the UK economy. Many of the larger market capitalisation stocks in the UK equity market are global multinationals which are much more tied to the global economy for their revenue generation than the UK economy. Many are largely unaffected by the tribulations of the UK economy.
Our investment manager feels strongly that the UK equity market often seems to be affected by negative investor sentiment over the UK economy and domestic outlook. As a result of this the UK equity market has become one of the cheapest markets in the world. Our investment manager continues to see considerable value opportunities within the market. Companies with robust business models and supportive long-term trends are now overlooked by investors who cannot see past a gloomy UK economic environment. The manager continues to actively manage the portfolio and take advantage of these new opportunities as they arise.
Market demand
Although this has been a challenging first half for the Trust, we have seen continuing demand for our shares illustrated by the share price continuing to trade around par with the Net Asset Value (NAV) for much of the period. Periodically the shares have traded at a premium to NAV, where we have consequentially issued new shares in the Company. Over the period 6,660,000 new shares were issued at an aggregate value of £37.9m, with a further 275,500 issued since 31 July up to the point of publishing these results. (As has been mentioned in previous reports shares are only ever issued at a premium to the prevailing Net Asset Value, to make the process accretive to existing shareholders. The board continues to believe that a growing trust benefits all shareholders as the company’s fixed costs can be spread over a wider base.)
Our strong and consistent long-term performance and our income generation, illustrated by our 41-year Dividend Hero status as defined by the Association of Investment Companies (AIC), are in our view the key factors behind ongoing shareholder and investor demand for Merchants’ shares.
Earnings
As noted above, we have continued to see an improvement in corporate earnings following the lows of the pandemic. Earnings per share (EPS) for the six months under review reached 17.4p (2022: 16.0p) which is now also comfortably above the pre-pandemic level of 16.1p for the equivalent period in 2019 (2020 financial year). Our investment manager necessarily remains somewhat cautious however on near-term earnings, given ongoing economic uncertainties and rising costs for businesses.
That said, the impact of the pandemic upon UK company dividend distributions was so profound, with some cuts and rebasing proving more permanent, it is very pleasing to be back well above pre-pandemic levels.
Dividends
There are two pleasing effects from the positive earnings noted above. Firstly, it has given the board confidence to propose an increased dividend and, secondly, it allows us to continue rebuilding revenue reserves that were partially utilised in order to continue our strategy of paying a high and rising dividend to shareholders through the pandemic. Not all trusts are able to provide such income support and smoothing during tough times, which is why Merchants is one of only 20 companies to be awarded the AIC’s coveted Dividend Hero status from a universe of well over 400 listed companies.
The board has declared a second quarter dividend for the current financial year of 7.1p per ordinary share, payable on 10 November 2023 to shareholders on the register at close of business on 6 October 2023. A Dividend Reinvestment Plan (‘DRIP’) is available for this dividend for which the relevant Election Date is 20 October 2023 and the ex-dividend date is 5 October 2023. We are pleased to advise that for CREST-registered shareholders, dividend payments are enabled in CREST. This means that for the first half of the 2024 financial year, the aggregated dividend will be 14.2p compared with 13.7p for the same period last year, a 3.6% year-on-year rise.
Shareholder contact
In 2022 we marked our first opportunity to host an in-person Annual General Meeting for shareholders since the pandemic. It was therefore a pleasure for the board to be able to once again host shareholders in May 2023. The board was pleased to see the event so well supported by shareholders and there was a lively dialogue between many of those shareholders, the board and our investment manager. I would like to thank those shareholders who managed to attend, but for those who couldn’t, a video of my introduction and portfolio manager, Simon Gergel’s investment update is available on Merchants’ website under the ‘Videos, Podcasts & Reading’ tab.
As you will hopefully be aware we spend considerable effort ensuring our reporting is informative and interesting for shareholders. It was a pleasure therefore to once again be nominated in the ‘Best Report and Accounts, Generalist’ award at the Association of Investment Companies’ annual awards. Having been a winner for three consecutive years, we were naturally disappointed not to have lifted the accolade this year, however congratulations to the winner and we are sharpening our pencils again ready for next year.
We continued to have positive press coverage during the period, but of particular note was a national press profile piece. After having already received a “buy” recommendation from The Times’ ‘Tempus’ column in January, The Daily Telegraph’s ‘Questor’ column at the end of March highlighted: “A strong track record of capital growth enhances Merchants Trust’s reputation for long-term performance”. After taking a deeper look at Merchants, columnist Robert Stephens concluded “With Merchants having a stunning track record of dividend growth over recent decades, plus an excellent history of capital returns, it offers a long-term solution to a long-term problem. Buy.”
Board
We reported in our latest Annual Report that the planned retirement dates of two directors had been noted and that the board would commence the process of conducting searches for suitable successors making use of external search consultants. That process has been initiated with the appointment of an external recruitment firm to assist with the process and we will keep shareholders informed as appropriate. In the Annual Report we confirmed the board’s support of the FCA’s encouragement of greater diversity on boards and we disclosed in line with the Listing Rules (LR 9.8.6R(9)). At present the board consists of three women and two men, and there are no directors with a minority ethnic background. We will be reporting on the outcome of the current recruitment exercise over the next few months.
Outlook
Central banks around the world continue to tread a tentative path around reducing inflation whilst trying to avoid recession. Recession may ultimately be unavoidable depending on how aggressive central banks decide to be. We note however that whilst that scenario can provide a challenge to the financial markets, assets such as the listed shares of companies often start to outperform well before the trough of an economic cycle. Our manager reminds us that any signals that inflation is moderating and that interest rates may fall could lead to investor sentiment improving very rapidly.
Uncertainty such as we have now is the enemy of calm and rational markets and so one might reasonably expect markets to continue to be very sensitive to news flow in the near term. For the dedicated stock picker this continues to provide opportunities where strong companies become caught up in general negativity and become, in the view of our manager, mispriced. He continues to see numerous opportunities to invest in good companies at attractive prices in the UK stock market which is one of the cheapest in the world and is currently trading near a 20-year low whilst its peer – the US equity market – is close to a 20-year high.
Whether the tech rally witnessed so far this year in the US is indicative of global markets having once again got ahead of themselves from AI-driven tech euphoria is still to be determined. Our manager continues to focus on the fundamentals of companies with strong business models and which are backed by clear long-term supportive themes. He continues to avoid distraction from short term news flow and stock market momentum. Merchants is positioned with a long-term focus and a clear emphasis on the value provided by the companies we invest in. We will maintain this focus in order to pursue continuing growth in income together with above-market total returns for Merchants’ shareholders.
Colin Clark
Chairman
25 September 2023