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26 September 2023

A Balancing act: Merchants Trust and the shifting tides of the UK Market

This article was taken from the August issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
We recently wrote at length about the challenges and opportunities that the recent bouts of market volatility have generated for investment trusts in the UK. In August we saw that discounts had reached their widest levels since 2008 and market sentiment is still far from optimistic. Given this backdrop, we thought it would be interesting to examine an investment vehicle that has bucked this trend.
 
Merchants Trust has weathered the recent storms better than most, despite being out of favour for much of the preceding decade. At the time of publication, the fund was trading at a premium of 0.5%, meaning the shares in the Trust were actually valued above its net asset value. The fund focuses mostly on UK large cap exposure with some smaller companies thrown into the mix when valuations look appealing. It has outperformed the FTSE 100 by 21.53% over the past five years and provided an absolute return of almost 40%. The fund’s change in fortunes is emblematic of the swing away from ultra-high growth, investors are increasingly favouring companies with strong balance sheets and well-covered dividends. These types of companies have been a cornerstone for Merchants Trust since its inception and, in times of market stress, people will pay for stability.
 
Merchants has long placed dividend payments at the heart of its investment strategy. The Trust has provided its investors with 41 years of consecutive dividend growth and is classified as one of the Association of Investment Companies ‘Dividend Heroes.’ At the time of publication, the Trust has a dividend yield of around 5.3% and, to ensure that this dividend is sustainable, it has primarily invested in established blue chip companies such as Shell, Barclays, BP, and Rio Tinto, all of which currently sit within the Trust’s top twenty holdings. The last few years have seen these industries swing back into favour. Banks have benefitted from rising interest rates as the returns they can achieve on loans have increased dramatically. Companies such as Shell have benefitted from high energy prices, but also from the strength of their balance sheet with the company generating high levels of free cash flow dating back to 2016. In times of market stress, this type of predictability becomes attractive to investors.
 
Many of the companies held in the Trust have now announced that they will be using the cash they have generated over the last few years to start buying back large portions of their equity, which should further bolster their share prices. Barclays recently announced that it will be buying back an additional £750m worth of its own shares, while Shell has announced that it will be purchasing a massive US$4bn worth of its own equity. This shows that they see themselves as undervalued and are attempting to create value for their existing shareholders. UK stocks have been somewhat out of favour since the 2016 Brexit referendum. However, the uptick in buybacks provides cause for cautious optimism in certain corners of the market and this Trust is well positioned to benefit. Currently, over 45% of the fund is concentrated in financials, industrials, and energy, all sectors which have been cash generative over the past few years and many of the Trust’s holdings are starting to buy back shares in large quantities.
 
The Trust is also one of a select few to currently be trading on a premium. This is reflective of the management team’s demonstrated ability to navigate the recent bouts of market volatility, the prospects of the underlying portfolio to continue to generate returns for investors, and the consistency with which Merchants has paid out a dividend. The persistent premium has allowed the Trust to issue new shares on several occasions. This has the effect of diluting the value of the shares, but also provides additional liquidity for the Trust and
allows for more widespread trading activity.
 
With hindsight, it might appear that Merchants Trust was destined to outperform over the last few years, but such hindsight bias ignores how out of favour the Trust had been for much of the preceding decade. Many of these industries were seen as dying and their resurgence was far from guaranteed. With inflation likely to remain high and interest rates unlikely to drop back down below 1% any time soon, the Trust’s immediate future looks rosy, but as few would have predicted its resurgence since 2019, it would be foolish to take this as a given.
 
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested
A Balancing act: Merchants Trust and the shifting tides of the UK Market

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