The Merchants Trust

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  • 09 mins 41 secs
Simon Gergel, Portfolio Manager, gives an update on the Merchants Trust and discusses his confidence in the fund outpacing inflation, the impact of cheaper borrowing, where he has seen the most value in 2017, the impact of Brexit on the fund and the challenges and opportunities he sees for 2018.


Allianz Global Investors
PRESENTER: For the latest update on the Merchant’s Trust, I’m joined by its Manager, Simon Gergel. Simon, good to have you with us today.


PRESENTER: So the Merchant’s Trust, 5% plus yield, this is certainly attention grabbing. So how can the Merchant’s Trust offer such a high yield compared to its peers in the UK equity income trust sector?

SIMON GERGEL: Well the first thing is we try and buy companies that yield in line with the market or above, and we actually think that’s a good place to be. If you look historically companies that have a high yield on average have outperformed the market in total return, not just in income, so that’s the first thing. And then we use some of the features of investment trusts to enhance that income. So for example we can borrow money, and that enhances the income we can pay out. We do a limited amount of covered call option overwriting. And also because the shares are trading at a discount shareholders get a higher yield than they would if the shares were trading at asset value.

PRESENTER: So let’s look at inflation now, and how confident are you that this yield will continue to outpace inflation?

SIMON GERGEL: Well in the long term the companies in the portfolio should be able to grow their earnings in real term, i.e. above inflation. And so the dividends that they deliver should be able to grow above inflation. In the shorter term, we’re benefiting from some quite good dividend growth in certain areas like life insurance. We’re seeing dividends recover in the banking sector, in the mining sector from when they were cut after the financial crisis. And we’re seeing a benefit of weaker sterling. Post Brexit we saw the currency depreciate, and much of our income comes over from overseas. So there’s quite a number of things which are giving us an extra income at the moment or slightly higher dividend growth coming through.

PRESENTER: So then can you talk me through the trust plans then to refinance a loan it took out in 1987?

SIMON GERGEL: Yes, well we’ve just announced a few weeks ago that the board have priced a new bond, a 35-year bond, at an interest rate under 3% to refinance the debt which was taken out in the 1980s. And the benefit of that is it will lead to a significantly lower interest cost for the overall trust, which again will enhance the earnings of the company, and again that could potentially allow slightly higher dividend growth.

PRESENTER: And what impact will this cheaper borrowing have on the portfolio, and is that good news for investors?

SIMON GERGEL: Well the cheaper borrowing is good news. The average cost of debt will come down significantly, and the earnings could go up by between 3 or 4% on a proforma basis. And that gives the board of directors a bit more flexibility on dividend policy, potentially they could increase the dividends further, or they could put more money away into reserves to be able to continue growing the dividend in the future. Alternatively, there’s a bit more flexibility potentially on the investment policy, although there are no plans at the moment to change that.

PRESENTER: So, looking at sectors now, and oil and gas had a good run this year. So what’s the prospects for 2018?

SIMON GERGEL: I think the oil and gas shares, the big oil companies like BP and Royal Dutch Shell, have surprised investors with the amount of cash they are capable of generating, even with a lower oil price than we had two or three years ago. So what you’re seeing so far this year is even with oil at $50-55 the companies are generating enough cash to invest in their business, sustain their business, to pay their financing costs, and to pay dividends out to shareholders, and cover those dividends fully. And that’s giving people a lot more confident that those dividend payments are sustainable.

So whereas the shares were yielding maybe 8% a year or two ago, they’re now typically yielding around 6%. We think that 6% dividend yield is still very attractive. There are few companies in the market that pay a sustainable 6% dividend yield. And so we think the shares could go considerably further than this. We still think they are very good value, and one of the areas of the market that’s much neglected I think by many investors.

PRESENTER: So where have you seen the most value in the UK for 2017?

SIMON GERGEL: Where we see the most value is really a flipside of where we see investors going. A lot of money is going into perceived safe companies, companies that can grow or are expected to grow at quite a high rate. And many of the other companies, many of the areas where there are issues, risks, are trading quite cheaply. So we’re finding good value in many recovery situations, where companies’ earnings might be depressed or under a certain pressure. Or companies that may be at risk from the slowdown in the UK economy, many of those types of shares are really quite lowly rated, and we’re seeing opportunities in those types of businesses.

PRESENTER: And considering all the political uncertainty that we’ve been seeing, why have stock markets been so buoyant?

SIMON GERGEL: Well it depends a bit on your timeframe. So we have had a strong market for four or five years, but if you look at the large companies in the FTSE 100 index for example, we’re only slightly above the level we were at back in 1999. So really for 16/17 years the market in terms of the very big companies has not gone very far at all. And we see within the market there are still, although some shares clearly are quite highly rated and have performed well, there are many companies that are really offering pretty good value at this level. So when we look at the strength of the market I think it is partly explained by very low interest rates and low government bond yields, and the search for income elsewhere. But equally we don’t think it’s overrun, we don’t think it’s gone too far particularly in terms of the UK equity market.

PRESENTER: And how tricky has it been to run a portfolio against the backdrop of Brexit?

SIMON GERGEL: The Brexit situation does create a lot of volatility, and certainly there have been some challenges, but it’s also created enormous opportunities. In the aftermath of the Brexit referendum result we were able to buy companies like Prudential at really well below the fair value of the company, because of the enormous volatility in the share price. So we are trying to take advantage of these periods of volatility in individual companies, and looking for bargains, and there are quite a lot of interesting situations at the moment, given that investors generally are quite negative about the outlook for the UK economy. It’s also worth saying of course that the UK stock market and indeed our portfolio is dominated by overseas earnings; most of the revenues, most of the profits that our companies in the portfolio generate come from abroad, and to some extent they’re not really that vulnerable to Brexit. So there’s a lot of focus understandably from commentators on Brexit, but many of the businesses we invest in aren’t really going to be that affected by it.

PRESENTER: And looking at rate rises, they have been creeping up but we’re still in this environment of historically low rates. So this recent rise we saw in the UK, do you think that signifies a change to rates?

SIMON GERGEL: I think technically we are now on a rate rising cycle, but I don’t think it’s going to be like the typical cycles we saw in the ‘80s and ‘90s. I think interest rates are going to grow, go up very slowly at a modest pace. Because there is not that much growth in the economy, and the Bank of England’s concerned to ensure that growth can be sustained, and they wouldn’t want to choke that off, and there’s a lot of debt out there. So for all those reasons I think interest rate rises are going to be very gradual and prolonged, and it’s not going to be a sharp cycle of rising rates. So we’re really going to remain in a low interest rate environment for quite a long time I think.

PRESENTER: And considering this rising rate environment we find ourselves in, albeit probably very slowly, what sort of impact could this have on the stocks that you hold in your portfolio?

SIMON GERGEL: Well I think many of the companies we own in the portfolio would actually benefit from rising interest rates. Some of the financial stocks like the banks and a few other companies benefit from a slightly stronger growth environment. And conversely many of the companies we don’t own, for example in the consumer staples area, beverages, food producers, they’ve performed very well as interest rates have come down, as bond yields have come down, because they’re seen as bond like equities, giving you a relatively safe and steady return. And I think many of those companies could underperform, so our portfolio could do quite well in that environment.

PRESENTER: And turning to 2018, what do you foresee as perhaps the challenges or indeed the opportunities?

SIMON GERGEL: I think there’s going to remain enormous focus on Brexit and whether the UK can get a transition deal. I think if we don’t get a transition deal within the next few months, then companies will have to start putting in place contingency arrangements, which could affect their employees, it can affect their investment intentions, and it could affect confidence more generally in the UK. Having said that of course, as I said earlier, only a certain proportion of the UK stock market and our portfolio is affected directly by what’s happening in the UK. So there will remain lots of challenges, lots of volatility at the individual company level, and lots of opportunities in 2018 as there have been in 2017.

PRESENTER: Well finally earlier I referred to the refinancing of the Merchant’s Trust loan in 1987, so where were you at that time, where were you working, and how have you see the market change?

SIMON GERGEL: Well I started working in the City in 1987, and it does feel like quite a different environment. At that point in time the economy was growing pretty fast, inflation was higher so the real growth was strong, and the nominal growth was even stronger. And on top of that the stock market had a, there was a lot of buoyancy, a lot of optimism, almost euphoria within the stock market leading up to the infamous crash in October 1987. I think at the moment life’s very different. Growth is modest. Inflation is very low so nominal growth is pretty challenging. Although the market’s been going up it’s been against a feeling of pessimism, I would say, or certainly concern out there on Brexit, on economic growth, on geopolitical issues. And so I don’t think you’ve got the runaway optimism in the market that we had then. It does feel in many ways we’re in a very different world now than the one we were back in 1987.

PRESENTER: Absolutely. Simon, thank you.

SIMON GERGEL: Thank you.