Half-year Report
26/09/2023 07:00
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RNS Number : 5947N Merchants Trust PLC 26 September 2023
LEI: 5299008VJFXCUD2EG312
THE MERCHANTS TRUST PLC
Half-Yearly Financial Report
For the six months ended 31 July 2023
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
Principal Risks and Uncertainties
As identified in the Annual Report, the principal risks are now considered to
be emerging risks, followed by the risks of market decline.
The principal risks and uncertainties facing the company, together with the
board's controls and mitigation, are those described in the Annual Report for
the year ended 31 January 2023 published in April 2023 and are listed below:
· Emerging risks, such as significant geopolitical risks.
· Risk of market decline adversely affecting investments and
returns.
· Investment strategy risk leading to a failure to meet the
company's
objectives, such as income generation and dividend growth.
· Risk of poor performance in difficult markets for the portfolio.
The board's approach to mitigating these risks and uncertainties is set out in
the explanation with the Risk Map in the Annual Report. In the board's view
these will remain the principal risks and uncertainties for the six months to
31 January 2024.
Going Concern
The directors have considered the company's investment objective and capital
structure both in general terms and in the context of the current
macro-economic background. Having noted that the portfolio is liquid as it
consists mainly of securities which are readily realisable, and through
continuous assessment of the company's financial covenants, the directors have
concluded that the company has adequate resources to continue in operational
existence for the foreseeable future. The directors have also considered the
continuing risks and consequences of macroeconomic and unanticipated shocks on
the operational aspects of the company and have concluded that the company has
the ability to continue in operation and meet its objectives in the
foreseeable future. For this reason, the directors continue to adopt the going
concern basis in preparing the financial statements.
Responsibility Statements
The directors confirm to the best of their knowledge that:
· The condensed set of financial statements contained within the
half-yearly financial report has been prepared in accordance with FRS102 and
FRS104, as set out in Note 2, the Accounting Standards Board's Statement
'Half-Yearly Financial Reports'; and
· The interim management report includes a fair review of the
information required by The Financial Conduct Authority's ('FCA') Disclosure
and Transparency Rule 4.2.7 R of important events that have occurred during
the first six months of the financial year and their impact on the condensed
set of financial statements, and a description of the principal risks and
uncertainties for the remaining six months of the financial year; and
· The interim management report includes a fair review of the
information concerning related parties transactions as required by the
Disclosure and Transparency Rule 4.2.8 R.
Colin Clark
Chairman
25 September 2023
Enquiries:
For further information, please contact:
Allianz Global Investors UK Limited
Stephanie Carbonneil
Head of Investment Trusts
Tel: 020 3246 7256
Investment Manager's Review
Major geopolitical events seem to have occurred at the start of recent
financial years, with the Covid pandemic spreading to Europe in February 2020
and the Russian invasion of Ukraine in February 2022. The start of this year
was not quite on the same scale, but there were important events,
nevertheless. Financial markets were rocked by the collapse of Silicon Valley
Bank (SVB) in California and the forced rescue of Credit Suisse by Union Bank
of Switzerland. Throughout the early months of the year, there was also a boom
in the valuation of the large US technology stocks driven by excitement over
generative artificial intelligence (AI). There was a hope that AI could lift
the technology sector out of a post-Covid slowdown. This hope was boosted when
Nvidia announced a surge in orders of its graphics chips that fuel AI.
Perhaps the dominant theme to affect the UK stock market was the continued and
stubborn rise in inflation. Western central banks had to raise interest
rates aggressively to try to stem inflationary pressures. As interest rate
expectations increased, bond yields rose and mortgage costs went up, raising
concern about the prospects for consumer spending and the economy more
broadly. Interest rate increases were also a contributory cause to the Silicon
Valley collapse, as rising bond yields hit the value of SVB's bond portfolio
and exposed specific vulnerabilities.
In the UK, 10 year government bond yields rose from 3.3% to 4.3% over the
period, with 2 year yields rising even higher, as the Bank of England raised
interest rates from 3.5% to 5%. Inflation statistics exceeded expectations for
most of the period, even as inflationary pressures started to subside in the
US and Europe, leading to a narrative that the UK had a worse inflationary
problem than elsewhere. It was only in July, when reported inflation came in
lower than expectations, that investors became a bit more optimistic about UK
inflation and the prospects for interest rates. Sterling strengthened against
the dollar in a move that generated little attention, especially compared to
the weakness of sterling last year, when Liz Truss was prime minister. The
pound rose from $1.23 to $1.28, well above the $1.07 hit last September.
The combination of rising economic concerns, stress in parts of the banking
system and a surge in excitement about AI, led to a sharp polarisation within
stock markets. In the US, most of the stock market gains were made by a
handful of large technology companies. In the UK, whilst the overall UK stock
market return was modest, with the market trading in a fairly tight range,
there was a large gap between the strong performance of higher growth
companies, and the weak performance of more lowly valued companies. Large
companies outperformed medium and smaller sized companies. The latter tend to
be more cyclical and more exposed to the domestic economy. The UK stock market
also suffered from continued investor outflows, on concerns about the UK's
inflation and interest rate outlook.
Sector performances were mixed. In many cases, the overall sector move
reflected the average of a wide range of different share price movements. For
example, within banks, HSBC benefitted from a relative "safe haven" status and
produced a 13% total return, whilst Barclays and NatWest gave negative returns
of between -14% and -18%. Of the largest sectors, the most notable move was
the 16% drop in the industrial metals & mining sector on concern about
weak growth in the important Chinese economy. Pharmaceuticals and personal
care outperformed, due to their defensive characteristics, whilst banks and
energy performed close to the market average.
The dispersion in share prices was also driven by a number of competing forces
that affected businesses. Some industries, like tourism and leisure
benefitted from a continued recovery to more normal levels of activity. Other
industries, like chemicals and packaging, had to deal with an excess of
inventory built up
during the Covid period, which had to be worked off, impacting sales. Rising
interest rates affected businesses in different ways, especially in the
financial sectors. House building in the UK slowed in response to rising
mortgage costs. In addition, companies had to deal with volatility in
commodity costs and exchange rates.
Performance
It was a difficult period for our value-oriented investment approach. The
portfolio total return was -2.3%, compared to a benchmark return of +0.8%. The
underperformance was due to stock selection within sectors. Sector strategy
was net positive, as the portfolio benefitted from a high exposure to the
construction & building materials sector, which performed well, and a low
exposure to metals & mining, which was weak.
The top ten individual positive and negative stock contributions to the
relative performance are shown in the table. These top ten contributors only
account for about a third of the underperformance, with the rest accounted for
by a tail of smaller impacts, reflecting broad underperformance of lowly
valued companies this year.
Two of the largest three negative contributors were HSBC and AstraZeneca.
Neither was owned in the portfolio, and both are very large companies that
performed well, boosting the FTSE All-Share return. There were smaller but
similar impacts from not owning Rolls Royce and Flutter.
Three financial companies were among the top ten negative contributors. Shares
in the wealth manager St James's Place fell in July, as the company announced
a fee reduction for certain longstanding clients who have been with the firm
for a decade. Whilst this will impact profitability, St James's remains a very
strong business with an attractive growth profile that we do not believe is
reflected in the valuation. OSB (Onesavingsbank) also fell in July as the
company announced that a certain group of mortgage customers were moving off
variable rate mortgages, onto cheaper fixed rate deals, at a faster pace than
previously. This meant that the bank had to change its expectations for the
profitability of these customers. We believe the shares over-reacted to the
news, and we took advantage of the depressed valuation to add to the holding.
Financial trading company IG Group's shares fell in March, when it reported a
relatively quiet quarter for trading activity by its client base, but overall
profitability has been supported by higher interest rates. IG's trading is
always subject to market volatility, but it is a highly profitable market
leading business, and remains well positioned, with long term growth
opportunities.
Elsewhere, the consumer goods company PZ Cussons, which owns Original Source,
Imperial Leather and other brands, suffered from a post-Covid drop in sales of
its Carex soap and sanitiser business, as well as economic volatility in its
large African business. However, we believe the relatively new management team
is making considerable progress in improving the quality of the company which
has good potential. National Express, now called Mobico group, suffered from a
shortage of drivers and high cost inflation in its school bus operations in
the USA, and its UK bus business. Finally, the specialist recruitment company
SThree de-rated sharply on economic concerns, although the business has been
quite resilient and has an excellent long term growth record.
Looking at the positive individual stock contributors, the top three were all
stocks that were not owned in the portfolio, but fell sharply, pulling back
the FTSE All-Share return. These were the two mining companies Anglo American
and Glencore, and the financial stock Prudential.
Three of the top ten contributors are involved in the building industry, with
all three having a large exposure to the USA, where construction and housing
trends have been stronger than the UK. Tyman, which has a large market share
in components for doors and windows, saw its shares rally from a very low
valuation on optimism about a recovery in the business, supported by strong
profit margin improvement reported in North America. The building materials
giant CRH reported robust trading and excited investors with a proposed shift
of its primary stock market listing to the USA. Ground engineering company
Keller also performed well, with its key US operation seeing a strong margin
improvement.
Elsewhere, BMW responded well to resilient conditions and high levels of
profitability in the car industry and reinsurer SCOR performed well on the
back of strong industry pricing. Pets At Home outperformed on the back of
trading results, where it reported 13% sales growth in its vet business and 6%
growth in its retail stores last year, despite a difficult consumer
environment. Finally, BAE Systems followed last year's strong gains with
further outperformance on the back of increasing defence spending and good
operational performance.
Contribution to Investment Performance relative to the FTSE All-Share Index
Positive Performance Negative Performance
Stocks
Stocks
Impact % Impact %
Overweight
(holding larger than index weight)
Tyman 0.3 St James's Place -0.5
BMW 0.3 PZ Cussons -0.3
SCOR 0.2 OSB -0.3
Pets At Home 0.2 Mobico -0.3
CRH 0.2 IG -0.3
BAE Systems 0.2 SThree -0.2
Keller 0.1
Underweight
(zero holding or weight
lower than index weight
Anglo American 0.5 HSBC -0.6
Prudential 0.3 AstraZeneca -0.4
Glencore 0.3 Rolls Royce -0.3
Flutter -0.2
Portfolio Changes
The wide range of share price movement in the UK equity market, coupled with
high dispersion between valuations, has created many new investment
opportunities and also the potential for sales from the portfolio. In
response, we have been quite active, adding four new companies and selling out
of five, as well as making significant changes to other position sizes.
Three of the four new holdings were medium sized companies, whilst the other
was a straight switch within the banks sector. We are generally finding the
best value among medium sized companies, which may be off the radar of global
investors. In our opinion, persistent outflows from UK equity funds have led
to forced selling pressure on many sound companies, without enough new money
to arbitrage out the value opportunities. Conversely, four of the five
disposals were large companies.
We made a new investment in building materials company Marshalls. Well known
for its paving products, Marshalls is diversified into commercial,
infrastructure, new housing and repair & maintenance products. It has an
attractive and growing presence in more sustainable areas, like concrete
products with a low carbon footprint, and complete roofing solutions with
integrated solar panels. Due to difficult trading conditions in the new
housing and renovation markets, Marshalls traded on a modest valuation for the
quality of the company and its strong market position.
We also bought Inchcape, the world's largest independent car distribution
company, which has exclusive relationships representing over 50 brands in more
than 40 countries. Some of these relationships date back decades. Inchcape is
consolidating a fragmented market as car manufacturers need strong partners in
the smaller markets, to provide the latest digital capabilities to consumers
and to manage an increasingly complex industry structure. We had sold out of
Inchcape shares on valuation grounds in 2021. Since then, the company has
grown rapidly via acquisition, with almost half group profits now coming from
Latin America. Some short-term concerns over a large recent transaction, had
upset investors, providing an opportunity for us to re-invest at what we
believed to be a compelling valuation, and below the price we had sold at in
2021. We did not believe the share price reflected the inherent strengths of
the company, or the considerable strategic progress it has made in the last
two years.
The other two new purchases were switches within financial sectors. We bought
Lancashire Holdings, a medium sized reinsurance company with a strong presence
in the Lloyd's of London market. Lancashire has a disciplined approach to
insurance, only committing capital when it views pricing as favourable. In the
last two years, it has built up its book of business rapidly as reinsurance
pricing has improved, and it should be a beneficiary of this stronger market
environment, as well as from higher interest rates, which boost investment
returns. We funded Lancashire partly by selling Swiss Re. Although Swiss Re is
also exposed to the same improving market conditions, its exposure is diluted
by a more diversified business model, and its valuation was significantly
higher than Lancashire where we saw more upside.
In the banks sector, we switched out of NatWest into Lloyds. Both banks are
well capitalised and benefitting from better industry conditions than in
recent years, with higher interest rates boosting margins and relatively low
bad debt charges, despite economic uncertainty. Both banks were modestly
valued, but we had a preference for Lloyds, given the scale advantage of its
leading position in UK consumer banking and an improving cash generation
profile.
Turning to the sales, we sold out of BAE Systems which has been in the
portfolio for many years. BAE is Britain's largest defence manufacturer and
also the country's largest manufacturing business. BAE has been trading well,
with a large order book and sound prospects. Selling the shares brought mixed
emotions. However, our job is not simply to own strong businesses on behalf of
shareholders, we are looking for exceptional investment opportunities. BAE
shares had been very strong performers, with the share price doubling over the
preceding two years, even excluding dividends. Our assessment was that the
shares had moved up to a fair valuation, and therefore we decided to exit the
position to fund more attractive situations. We wrote up the BAE Systems
investment as a case study in the 2023 annual report, reflecting its strong
contribution to last year's results.
The other two complete disposals were Vodafone and Ashmore. In our investment
process, there are three reasons for selling an investment. First, it may
reach our target price. BAE systems was such a case. Second, the investment
view may have changed. And third, there may be better opportunities elsewhere.
Both of these sales were examples of the second reason: a change in investment
view. Changes of opinion are often the most psychologically difficult
decisions. They usually follow a period of poor stock performance. Either, we
have to admit to being wrong about our initial investment decision, or we have
to recognise that something has fundamentally changed to challenge our initial
view. Both can be uncomfortable, but it is important to be as objective as we
can.
Investing in Vodafone had been a poor investment decision. Having not owned
the company for many years, due to concerns over the highly competitive
industry structure and the need for persistently high capital expenditure, we
bought a position during the pandemic as we liked its strong cash generation,
a high dividend yield and limited economic sensitivity. We also saw some signs
that the business was performing better. However, that business improvement
proved short-lived. We sold part of the investment last year, close to the
original cost price, as our level of conviction declined, but we held onto the
rest, and only sold it in June after another trading disappointment. Whilst
the share price was lower, we had to recognise that our initial investment
case was wrong, and we did not have sufficient confidence to maintain a
position.
Ashmore was a slightly different situation. It is a leading emerging market,
predominantly fixed income, fund management business, with a strong culture
and a differentiated market position. Merchants has owned Ashmore previously
and made a good return. When we bought back into the shares in 2021, Ashmore's
funds had been through a period of poor performance, and it had seen outflows.
Our investment case was built around the potential for a cyclical recovery in
the emerging markets asset class, improvement in the company's funds'
performance and ultimately a strong pick up in profitability. However,
performance and flows were worse than we expected, making it more challenging
for the business to retain assets and to take advantage of an eventual
recovery. Like Vodafone, we had already sold part of the holding earlier in
the year as our level of conviction declined and we decided to sell the rest.
Apart from these new purchases and total disposals, we made a large number of
changes to position sizes. The biggest additions included Drax, the UK's
largest renewable power generator, Energean, which is ramping up production of
gas in Israel, helping the country to reduce its dependence on highly
polluting coal fired power generation, and the pharmaceutical and vaccines
business GSK. All three are lowly priced companies where we have high
conviction. The biggest partial sales included the building materials company
CRH, which had performed very well as discussed above. We also reduced three
consumer companies that had all rallied and re-rated closer to fair value.
Unilever and Tesco have relatively defensive business models, manufacturing
and selling every-day food and consumer products. The car company BMW is a
more cyclical business, but trading in the industry has been robust, despite a
nervous consumer environment, as limited car production during Covid had kept
new and used car supply constrained and boosted prices.
As well as making portfolio changes, we continued to actively engage with
companies in the portfolio as part of our ongoing stewardship process. Many of
these engagements covered the risk of climate change and how companies plan to
reduce their greenhouse gas emissions over time, particularly in the
extractive and energy industries. In the case of banks, the issue is more
about how they incorporate climate change risks into their business processes,
both in terms of credit risk and in terms of the emissions of the companies
they finance. We also had several engagements on more traditional governance
areas, such as capital allocation policies and remuneration structures. A
particular feature of the discussions this year, has been how companies think
about returning surplus capital to shareholders, either via share buy-backs or
special dividends. With many shares trading at low valuations, the case for
buy-backs is stronger than it may have been historically.
Income
We have been pleased by the steady improvement in the income generation of the
portfolio, with strong dividend growth continuing in industries like banking
and oil & gas, which have seen a substantial recovery in profitability
since the pandemic period. Higher inflation is also feeding through to higher
dividend growth, either in industries where pricing is directly linked to
inflation, like utilities, or more indirectly through higher nominal sales and
profits. We have been encouraged by the operational progress that many of the
portfolio companies have made, which also supports their dividend growth.
Of course, it has not all been plain sailing. The consumer environment is
difficult, and sectors like housing are seeing a sharp slowdown. This means
that there are likely to be some dividend cuts in the portfolio in the months
ahead. But we do not envisage wholesale dividend cuts like we saw during the
pandemic or the Great Financial Crisis, partly due to the considerably
stronger balance sheets of many of the businesses in the portfolio.
Overall, higher income receipts have boosted Merchants revenue earnings per
share to 17.4p, an increase of 8.7% compared to 16.0p last year.
Economic and Market Outlook
In our opinion, the UK stock market offers exceptional opportunities for
investors. According to Goldman Sachs, the UK stock market is trading close to
its lowest absolute valuation in the last 20 years, in terms of price to
earnings ratio, at the same time that the USA is trading close to its highest
level. That is unusual in itself. But, in addition, the dispersion of
valuations across the UK stock market (the gap between growth and value
stocks) is around the widest it has been in 50 years, according to Morgan
Stanley. These are conditions, that I don't remember seeing before in my
career. Many sound businesses are trading on depressed valuations, offering
the potential to make very healthy capital and income returns. To understand
why this is the case, and why conditions may change, it is worth discussing
the circumstances that have led to this unusual situation.
Since the Brexit referendum in June 2016, the UK stock market has been out of
favour with international investors, and it has gradually de-rated. Initially,
this was driven by fears over the economic impact of Brexit itself, and this
was exacerbated by the tortuous political wranglings with the EU during
Theresa May's and Boris Johnson's premierships. Political uncertainty
increased, when Jeremy Corbyn, a hard-left leaning politician looked like he
could win the general election in 2019. Then, just as the Brexit and political
uncertainty started to fade, following Johnson's emphatic election win in
2019, the Covid pandemic hit in early 2020, and the UK seemed to suffer
especially hard, providing another reason for foreign investors to stay away.
Next, as the pandemic was fading into the rear-view mirror, the Russian
invasion of Ukraine caused a huge inflationary spike that particularly
affected Europe, giving global investors reason to stay clear of the whole
continent. Further political uncertainty ensued when Liz Truss became prime
minister for a brief period in 2022 and unsettled the financial markets with
what were perceived as unfunded tax cuts. Finally, more recently, as discussed
above, the UK's inflation rate has been higher and more sticky than the rate
in the US and the EU, creating a narrative that the UK has a more challenging
outlook.
These concerns about the UK, have led to steady outflows from UK equity funds
in recent years. This comes on the back of a structural, forty-year period,
where domestic pension funds and institutions have gone from owning around
half the UK stock market, to only 4%. The selling has largely been due to the
increasing maturity of defined benefit pension funds, and accounting rules
which encouraged funds to sell equities and buy bonds. This selling pressure
has exacerbated the de-rating of the stock market, and widened the gulf
between those companies that are popular with global investors - typically the
large multi-nationals and the higher growth / higher return companies - and
the rest. It has often felt like there were no buyers for some of the medium
sized and smaller companies, and it not surprising that we have seen a step-up
in the number of portfolio companies buying back their own shares, to take
advantage of the bargain prices available.
Whilst some people may see this set of circumstances as a reason to shun UK
equities, we see the glass as half-full. The selling pressure by domestic
pension funds and institutions really cannot go much further, as they own very
few UK equities. Furthermore, the government is keen to promote the UK stock
market, and to get domestic savers and institutions to support investment and
innovation. This may take time to have any effect, but the relentless selling
should be nearly finished. The latest inflation numbers suggest that the UK is
nearing the peak of the inflation cycle and any visibility on peak interest
rates could lead to a significant change in depressed investor sentiment. UK
politics seems to be becoming less polarised, with the policy gap between
Rishi Sunak and Sir Keir Starmer quite narrow, removing one of the often-cited
reasons for avoiding UK investments. Most importantly, the valuations of many
UK companies are compelling, especially compared to their peers overseas,
despite the majority of sales of UK listed companies actually coming from
abroad. We would expect to see a resurgence in takeover activity, as companies
and private equity funds look to take advantage of this situation. The cost of
debt and volatility of interest rates may keep some of these investors on the
sidelines for a while longer, but once the interest rate cycle looks more
supportive, sentiment could change rapidly.
We are therefore excited about the prospects for Merchants' portfolio. It is
diversified across industries and geographic exposure, as well as between
defensive and more cyclical businesses. But it is a portfolio of strong
businesses, trading on very modest valuations, and paying an income stream
well in excess of the broader stock market.
Simon Gergel
Allianz Global Investors
THE MERCHANTS TRUST PLC
Twenty Largest Equity Holdings as at 31 July 2023
Value % of Benchmark
Name £'000s Holdings Weightings Sector
41,318 4.7 2.4 Pharmaceuticals & Biotechnology
GSK
Shell 40,308 4.6 6.9 Oil, Gas & Coal
British American Tobacco 32,694 3.7 2.5 Tobacco
Rio Tinto 29,355 3.4 2.4 Industrial Metals & Mining
BP 28,724 3.3 3.6 Oil, Gas & Coal
DCC 27,511 3.1 0.2 Industrial Support Services
IG Group 26,753 3.1 0.1 Investment Banking & Brokerage
WPP 25,889 3.0 0.4 Media
Energean 25,071 2.9 0.1 Oil, Gas & Coal
Inchcape 24,555 2.8 0.1 Industrial Support Services
SSE 24,355 2.8 0.8 Electricity
Tate & Lyle 24,330 2.8 0.1 Food Producers
Imperial Brands 23,447 2.7 0.7 Tobacco
Redrow 20,706 2.4 0.1 Household Goods & Home Construction
Drax Group 20,321 2.3 0.1 Electricity
Barclays 19,912 2.3 1.0 Banks
Next 19,729 2.3 0.4 Retailers
St. James's Place 19,270 2.2 0.2 Investment Banking & Brokerage
Pets At Home Group 18,077 2.1 0.1 Retailers
Grafton Group 17,693 2.0 0.1 Industrial Support Services
510,018 58.5 % of Total Invested
Funds
Portfolio Analysis as at 31 July 2023
Sector % Held Benchmark weighting
Financials 22.6 22.2
Consumer Staples 14.0 15.0
Industrials 18.1 12.2
Consumer Discretionary 14.8 11.9
Energy 12.2 10.8
Utilities 7.0 3.5
Health Care 7.5 11.3
Basic Materials 3.9 7.4
Real Estate 2.0 2.4
Net current liabilities -2.2
100.0
May not add up due to roundings
** Total Assets include current liabilities
THE MERCHANTS TRUST PLC
Summary of Unaudited Results
INCOME STATEMENT
For the six months ended 31 July 2023
Revenue Capital Total Return
£'000s £'000s £'000s
(Note 1)
Losses on investments held at fair value through profit or loss - (45,784) (45,784)
Losses on foreign currencies - (15) (15)
Income from investments 27,147 - 27,147
Other income 655 - 655
Investment management fee (556) (1,033) (1,589)
Administrative expenses* (603) (2) (605)
Profit (loss) before finance costs and taxation 26,643 (46,834) (20,191)
Finance costs: interest payable and similar charges (937) (1,700) (2,637)
Profit (loss) on ordinary activities before taxation 25,706 (48,534) (22,828)
Taxation (679) - (679)
Profit (loss) after taxation attributable to ordinary shareholders 25,027 (48,534) (23,507)
Earnings (loss) per ordinary share (Note 4)
(basic and diluted) 17.36p (33.67p) (16.31p)
BALANCE SHEET £'000s
As at 31 July 2023
Fixed Assets
Investments held at fair value through profit or loss 893,161
Net current liabilities (19,293)
Total assets less current liabilities 873,868
Creditors: amounts falling due after more than one year (66,838)
Total net assets 807,030
Called up share capital 36,699
Share premium account 220,520
Capital redemption reserve 293
Capital reserve 521,378
Revenue reserve 28,140
Equity shareholders' funds 807,030
Net asset value per ordinary share 549.8p
The net asset value as at 31 July 2023 is based on 146,794,887 ordinary
shares.
*Administrative expenses for 2022 included the London Stock Exchange block
listing fee of £170,000.
THE MERCHANTS TRUST PLC
Summary of Unaudited Results
INCOME STATEMENT
For the six months ended 31 July 2022
Revenue Capital Total Return
£'000s £'000s £'000s
(Note 1)
Losses on investments held at fair value through profit or loss - (18,646) (18,646)
Gains on foreign currencies - 29 29
Income from investments 22,997 - 22,997
Other income 439 - 439
Investment management fee (515) (957) (1,472)
Administrative expenses* (690) (1) (691)
Profit (loss) before finance costs and taxation 22,231 (19,575) 2,656
Finance costs: interest payable and similar charges (634) (1,137) (1,771)
Profit (loss) on ordinary activities before taxation 21,597 (20,712) 885
Taxation (490) - (490)
Profit (loss) after taxation attributable to ordinary shareholders 21,107 (20,712) 395
Earnings per ordinary share (Note 4)
(basic and diluted) 16.04p (15.74)p 0.30p
BALANCE SHEET £'000s
As at 31 July 2022
Fixed Assets
Investments held at fair value through profit or loss 841,088
Net current liabilities (11,753)
Total assets less current liabilities 829,335
Creditors: amounts falling due after more than one year (66,782)
Total net assets 762,553
Called up share capital 33,731
Share premium account 157,058
Capital redemption reserve 293
Capital reserve 547,640
Revenue reserve 23,831
Equity shareholders' funds 762,553
Net asset value per ordinary share 565.2p
The net asset value as at 31 July 2022 is based on 134,924,887 ordinary
shares.
*Administrative expenses for 2022 included the London Stock Exchange block
listing fee of £170,000.
BALANCE SHEET £'000s
As at 31 January 2023
Fixed Assets
Investments at fair value through profit or loss 909,638
Net current liabilities (30,454)
Total assets less current liabilities 879,184
Creditors: amounts falling due after more than one year (66,809)
Total net assets 812,375
Called up share capital 35,034
Share premium account 184,239
Capital redemption reserve 293
Capital reserve 569,912
Revenue reserve 22,897
Equity shareholders' funds 812,375
Net asset value per ordinary share 579.7p
The net asset value as at 31 January 2023 is based on 140,134,887 ordinary
shares.
THE MERCHANTS TRUST PLC
STATEMENT OF CHANGES IN EQUITY
Called Up Share Premium Capital Redemption Reserve
Share Account £'000s Capital Revenue Reserve
Capital £'000s Reserve £'000s Total
£'000s £'000s £'000s
Six months ended 31 July 2023
Net assets at 1 February 2023 35,034 184,239 293 569,912 22,897 812,375
Revenue profit - - - - 25,027 25,027
Dividends on ordinary shares (Note 3) - - - - (19,784) (19,784)
Capital loss - - - (48,534) - (48,534)
Shares issued during the period 1,665 36,281 - - - 37,946
Net assets at 31 July 2023 36,699 220,520 293 521,378 28,140 807,030
Six months ended 31 July 2022
Net assets at 1 February 2022 31,926 118,047 293 568,352 20,432 739,050
Revenue profit - - - - 21,107 21,107
Dividends on ordinary shares (Note 3) - - - - (17,708) (17,708)
Capital loss - - - (20,712) - (20,712)
Shares issued during the period 1,805 39,011 - - - 40,816
Net assets at 31 July 2022 33,731 157,058 293 547,640 23,831 762,553
THE MERCHANTS TRUST PLC
CASH FLOW STATEMENT
Six Months Six Months
ended 31 July 2023 ended 31 July 2022
£'000s £'000s
Operating activities
(Loss) profit before finance costs and taxation (20,191) 2,656
Add: Losses on investments held at fair value 45,129 17,696
Add: Losses (gains) losses on foreign currency 15 (29)
Purchase of fixed asset investments held at fair value through profit or loss (132,771) (176,160)
Sales of fixed asset investments held at fair value through profit or loss 107,145 130,106
Transaction costs (655) (950)
Increase in other receivables (2,473) (1,569)
Decrease in other payables (116) (87)
Less: Overseas tax suffered (679) (490)
Net cash outflow from operating activities (4,596) (28,827)
Financing activities
Interest paid (2,475) (1,725)
Dividends paid on cumulative preference stock (21) (21)
Dividends paid on ordinary shares (19,784) (17,708)
Share issue proceeds 37,946 41,109
Net cash inflow from financing activities 15,666 21,655
Increase (decrease) in cash and cash equivalents 11,070 (7,172)
Cash and cash equivalents at the start of the period 11,465 18,626
Effect of foreign exchange rates (15) 29
Cash and cash equivalents at the end of the period 22,520 11,483
Composed of:
Cash at bank 22,520 11,483
THE MERCHANTS TRUST PLC
Notes to the Financial Statements
Note 1 - Financial Statements
The half-yearly financial report has been neither audited nor reviewed by the
company's auditors. The financial information for the year ended 31 January
2023 has been extracted from the statutory financial statements for that year
which have been delivered to the Registrar of Companies. The auditors' report
on those financial statements was unqualified and did not contain a statement
under section 498 of the Companies Act 2006.
The total return column of the Income Statement is the profit and loss account
of the company.
All revenue and capital items derive from continuing operations. No operations
were acquired or discontinued in the period.
Allianz Global Investors UK Ltd acts as Investment Manager to the company.
Details of the services and fee arrangements are given in the latest annual
report of the company, which is available on the company's website at
www.merchantstrust.co.uk.
Note 2 - Accounting Policies
The Company presents its results and positions under 'The Financial Reporting
Standard applicable in the UK and Republic of Ireland' (FRS 102), which forms
part of the Generally Accepted Accounting Practice ('UK GAAP') issued by the
Financial Reporting Council.
The condensed set of financial statements has been prepared on a going concern
basis in accordance with FRS 102 and FRS 104, 'Interim Financial Reporting'
and the Statement of Recommended Practice - 'Financial Statements of
Investment Trust Companies and Venture Capital Trusts' ('SORP'). The context
of the current macro-economic background has been thoroughly considered and
the directors have concluded that there are no material uncertainties related
to going concern. They have also been prepared on the assumption that approval
as an investment trust will continue to be granted.
The interim financial statements and the net asset value per share figures
have been prepared in accordance with FRS 102 using the same accounting
policies as the preceding annual accounts.
Note 3 - Dividends on Ordinary Shares
Dividends paid on ordinary shares in respect of earnings for each period are
as follows:
Six months Six months
ended ended
31 July 2023 31 July 2022
£'000s £'000s
Third interim dividend 6.9p paid 15 March 2023 (2022 - 6.85p) 9,669 8,758
Final dividend 7.0p paid 26 May 2023 (2022 - 6.85p) 10,115 8,950
19,784 17,708
In accordance with FRS 102 section 32 'Events After the End of the Reporting
Period', dividends payable at the period end have not been recognised as a
liability. Details of these dividends are set out below.
Six months Six months
ended ended
31 July 2023 31 July 2022
£'000s £'000s
First interim dividend 7.10p paid 24 August 2023 (2022 - 6.85p) 10,412 9,208
Second interim dividend 7.10p payable 10 November 2023 (2022 - 6.85p) 10,422 9,242
20,834 18,450
The dividends above are based on the number of shares in issue at the period
end. However, the dividend payable will be based upon the number of shares in
issue on the record date and will reflect any purchase or cancellation of
shares by the company settled subsequent to the period
end.
Note 4 - Earnings per Ordinary Share
The earnings per ordinary share is based on a weighted number of ordinary
shares 144,134,526 (31 July 2022 - 131,625,080) in issue.
Note 5 - Fair Value Hierarchy
Investments and derivative financial instruments are designated as held at
fair value through profit or loss in accordance with FRS 102 sections 11 and
12.
FRS 102 sets out three fair value levels.
Level 1: The unadjusted quoted price in an active market for identical assets
or liabilities that the entity can access at the measurement date.
Level 2: Inputs other than quoted prices included within Level 1 that are
observable (i.e., developed using market data) for the asset or liability,
either directly or indirectly.
Level 3: Inputs are unobservable (i.e., for which market data is unavailable)
for the asset or liability.
With the exception of those financial liabilities measured at amortised cost,
all other financial assets and financial liabilities are either carried at
their fair value or the balance sheet amount is a reasonable approximation of
their fair value.
As at 31 July 2023, the financial assets at fair value through profit and loss
of £893,086,000 (31 July 2022: £841,080,000; 31 January 2023: £909,618,000)
are categorised as
follows:
Level 1 Level 2 Level 3 Total
£'000s £'000s £'000s £'000s
Financial assets at fair value through profit or loss at 31 July 2023
Equity investments 893,161 - - 893,161
Financial instruments - - - -
Derivative financial instruments - written call options - (75) - (75)
893,161 (75) - 893,086
Financial assets at fair value through profit or loss at 31 July 2022
Equity investments 841,088 - - 841,088
Financial instruments - - - -
Derivative financial instruments - written call options - (8) - (8)
841,088 (8) - 841,080
Financial assets at fair value through profit or loss at 31 January 2023
Equity investments 909,638 - - 909,638
Financial instruments - - - -
Derivative financial instruments - written call options - (20) - (20)
909,638 (20) - 909,618
For exchange listed equity investments the quoted price is either the bid
price or the last traded price depending on the convention of the relevant
exchange. For written options the value of the option is marked to market
based on traded prices. Financial instruments valued using valuation
techniques level 3 have, in the absence of relevant trading prices or market
data, been valued based on the directors' best estimate.
Note 6 - Status of the Company
The company applied for and was accepted as an approved investment trust for
accounting periods commencing on or after 1 February 2013, subject to it
continuing to meet eligibility conditions at section 1158 Corporation Taxes
Act 2010 and the on-going requirements for approved companies in Chapter 3
Part 2 Investment Trust (Approved Company) (Tax) Regulations 2011 (Statutory
Instrument 2011/2999).
Note 7 - Transactions with the Investment Manager and related parties
As disclosed in the annual report, the existence of an independent board of
directors demonstrates that the company is free to pursue its own financial
and operating policies and therefore, under FRS 8: Related Party Disclosures,
the investment manager is not considered to be a related party. The company's
related parties are its directors.
There are no other identifiable related parties as at 31 July 2023, 31 July
2022 and 31 January 2023.
The half-yearly financial report will be sent to shareholders at the end of
September 2023 and will be available to members of the public from the
company's registered office at 199 Bishopsgate, London EC2M 3TY or by calling
the Investor Services Helpline on 0800 389 4696.
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