Merchants Trust: Time to shine

The top performing UK Equity Income trust looks well-placed to benefit from the continued rotation from value to growth.

The £850m Merchants Trust (LON: MRCH) aims to provide shareholders with an above-average and growing level of income, as well as long-term capital growth. It does this by investing in a concentrated portfolio of large cap UK stocks, with the managers looking for materially undervalued quality companies on a bottom up basis, while also taking into account secular industry themes.

It is an approach that has paid off handsomely in recent times with the trust being the top performer in the UK Equity Income sector over both the last twelve months and the last three years – it was up 33% in 2021 alone. The managers believe that there is further upside to come and the 4.7% yield with its unbroken 40-year record of rising dividends is an attractive feature in these inflationary times.

Merchants is trading close to its underlying NAV and has been able to issue a significant volume of new shares to tap the excess demand. The analysts at Winterflood have a high regard for the experienced management team and believe that the current rating may well be sustainable given the UK dividend recovery and the medium-term performance record.

Portfolio approach

Manager Simon Gergel and his team have a value and contrarian bias, while limiting the downside risk by focusing on well-established, large UK companies. Stock selection is based on material undervaluation, which means that there is a cushion where profit margins are under pressure, such as through input cost increases.

Gergel has found value outside of the normal areas associated with this type of approach in sectors such as energy, mining and banks. Another differentiator is that he and his team are not opposed to holding growth stocks, as long as the fund doesn’t overpay compared with the fundamentals.

They have put together a concentrated portfolio of high conviction ideas that consisted of 50 stocks at the start of May. The largest positions include names like Glaxo, British American Tobacco, Imperial Brands, Shell, BAE and Rio Tinto, with the main sector allocations being financials, consumer staples, industrials and consumer discretionary.

Outlook

The managers believe that UK valuations remain cheap relative to their history and peers, as illustrated by a spate of overseas takeover bids. Because of this they are finding a wide opportunity set, despite the complications created by the inflationary pressures.

One area they like is the energy sector that makes up about 10% of the portfolio as they don’t think that the current high power prices are fully reflected in company valuations. They believe that underinvestment has led to structural undersupply and that prices will remain elevated, albeit not at today’s levels.

Merchants is more or less back to where it was before the sell-off at the start of the pandemic and has significantly outperformed perennial favourites like City of London (LON: CTY) over the last five years. It is yielding an attractive 4.7% that will shortly be fully covered by earnings and has an unbroken 40-year record of increasing the pay-out, which puts it firmly in the AIC’s dividend heroes’ category.