Simon Gergel, lead manager of The Merchants Trust, discusses a polarised stockmarket, always being a value investor and the importance of being open-minded.
The Monday Manager series covers fund managers that have worked on their fund for over three years, and where fund assets are over £100m.
Can you explain Merchants Trust’s approach to investing, and what the trust is trying to achieve for investors?
The Merchants Trust aims to provide a high and rising income stream and a strong total return through investing predominantly in larger UK equities. Merchants has raised the dividend for 44 consecutive years and had a dividend yield of 4.7% on 17 April.
The portfolio comprises between 40-60 companies, of which over 90% are listed on the UK stockmarket. Our investment approach is to look for strong businesses, trading well below their fair value, paying particular attention to long term structural themes. This “value” based approach means that the portfolio often has a contrarian style, picking up shares that are currently out of favour, but represent longer-term opportunities.
The FTSE All Share has achieved stellar (albeit volatile) returns over the past year. Has this made your job easier, or more difficult?
I am not sure it has made a huge difference. The strong recent performance of the UK stockmarket has been “hiding in plain sight”. There still seems to be a perception the UK is an unattractive place to invest, despite recent stockmarket gains, and even though the majority of profits from UK-listed companies, comes from abroad.
Although the market has been strong, its performance has been polarised, with a few sectors such as banks, aerospace & defence, and more recently oil & gas, performing extremely well. The sharp divergence between different sectors can create short-term challenges as a stockpicker, as relative performance depends on positioning in a few specific sectors.
But it also creates opportunities for contrarian investors to pick up strong businesses at attractive valuations, if they have been left behind in the market rally. We believe there are some extreme examples of undervalued companies which makes it an exciting time to be an investor in the UK.
Which areas of the UK market are you most excited about right now, and which are you avoiding?
There are opportunities in quite a few different sectors, but there is an unusual opportunity among medium sized and smaller companies. On average, medium-sized companies currently pay a significantly higher dividend yield than larger companies, which rarely happens, and supports the idea that many medium-sized companies may be undervalued.
In particular, because investors are nervous about the outlook for the UK economy, many domestically focused sectors have been neglected. More specifically, we can find attractive shares in the building and construction sectors. The UK has an acute housing shortage and ageing infrastructure. We expect home construction and general building activity to improve in the next few years, and that should support the building industries. With valuations at a low point, this looks attractive for investors willing to look beyond shorter term challenges. In a similar vein we have significant investments in the real estate sector where valuations are also quite depressed.
There are not many sectors we are avoiding entirely, but aerospace & defence stocks are pricing in many years of strong growth and little risk, and some of the banks now look more fully valued after strong share price gains.
What drew you to becoming an investment trust manager, and how did you end up specialising in UK equity income?
I think the structure of investment trusts with permanent capital, an independent board of directors, and the potential to use gearing, are well suited to investors who want to follow a long-term, often contrarian investment strategy. The trust structure means I can invest in companies of all sizes, without worrying about having to meet large redemptions. The structure also makes it possible to smooth dividends to shareholders and pay rising amounts each year.
I have always been a value investor, and I moved into income funds in around 2002 when an opportunity arose within my team at the time. Income and value investing are closely linked. Many lowly priced shares also pay a high dividend yield. However, one of the key things to remember in both disciplines, is that company fundamentals are critical. Many lowly priced or high yielding shares deserve those low valuations, they may be “value traps”. A high yield, in itself, is not a sufficient reason to buy a share. We are looking to identify those lowly priced stocks which are genuinely desirable, but where the price doesn’t reflect that.
What’s the best piece of advice you have ever received about investing?
I like the quote, “It is important to be open-minded, but not so much that your brain falls out”. This has been cited to Carl Sagan, referring to science, but is equally true in investing.
How much focus should investors have on generating income at the moment, as well as capital gains? Why?
Some investors may need income, to meet regular costs, others may not need income, so I cannot give any general advice on this. However, I think there are many strong businesses, trading on low valuations that pay a decent dividend yield, and also have the potential to deliver strong capital growth over the medium term.
At the Merchants Trust we aim to build a portfolio of such shares and to smooth the dividend payments. The objective is to provide investors both a steadily growing income stream but also capital growth. And, of course, investors who don’t currently need an income can always choose to reinvest that income in the purchase of further shares, thereby compounding any capital returns over time. Historically in the UK, higher yielding shares have tended to outperform the market, so it has been possible to have your capital return cake and eat the dividends too.
