High-yielding shares and looking outside FTSE 100 for income

In the first part of this Insider Interview, Simon Gergel, manager of The Merchants Trust Ord (LSE:MRCH), discusses some of the high-yielding shares he’s backing in order to deliver on the trust’s aim of providing an above average level of income.

He outlines its highest-yielding stocks, explains why he's finding more value than usual among mid-cap companies, and why he’s focused on “where we can make money” rather than just putting the emphasis on companies with dependable dividends.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Simon Gergel, manager of The Merchants Trust. Simon, thanks for coming in today.

Simon Gergel, manager of The Merchants Trust: Hi Kyle, nice to meet you.

Kyle Caldwell: To kick off, the investment trust aims to provide an above-average level of income, and you’re also looking for long-term growth. How do you define aiming to provide an above-average level of income? Do you target a particular dividend yield, and do you target a particular level of dividend growth?

Simon Gergel: We don’t target a specific level of yield or dividend growth because clearly the market yields go up and down, but the yield on Merchants Trust has been significantly higher than the overall market for many years. What we do target though is to grow that dividend every year and we’ve grown it every year for quite a long time.

Kyle Caldwell: You typically focus more on the FTSE 100 index when looking for high-yielding companies. However, as we’ll come on to a bit later on, you have been spotting more opportunities within the medium-sized and smaller-sized UK companies. Could you run through the current split in terms of company size in the portfolio?

Simon Gergel: Yes, so the trust’s stated objective is to be predominantly invested in large companies in the UK. But we have moved quite a long way into mid-caps, where we’ve found a lot of value.

At the moment, we’ve got about 55% to 60% in the largest companies, including a very small amount internationally. And we’ve got about 35% in mid- caps, and maybe 4% or 5% in small caps and a little bit of cash.

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Kyle Caldwell: And how many companies do you have overall? What’s the typical range?

Simon Gergel: It’s about 53 at the moment and the range is normally 40 to 60, and we’ve been in that range for many years.

Kyle Caldwell: And Merchants, it has an above-average dividend yield. Is it typically a certain percentage over the index?

Simon Gergel: It’s around about 25%, but it does move, so the yield at the moment is around 4.5% to 5%, but it moves day to day.

Kyle Caldwell: And when you’re examining the entire UK market, how do you ensure that when you are investing in a company that’s paying a high dividend yield, that its dividend is going to be sustainable over time?

Simon Gergel: Well, it might surprise you, but actually the way we do it is to try to find companies where we think we can make money.

So, we do want them to have a yield when we buy them, but we take the approach that if you just focus on companies where the yield is sustainable and almost guaranteed or very secure, you may miss a lot of other opportunities.

There are cyclical businesses that from time to time might cut their dividends in cycle that might be very cheap and might be good investments. And there can be other companies that, for all sorts of reasons, might potentially cut their dividend, and that doesn’t prevent us investing. We look for companies where we can make money. And, ultimately, if you make money on a share, you can reinvest in another company paying income in the future. So, that is our priority. It’s always about total return. It’s not about the income on any individual company.

Kyle Caldwell: So, while it would be on a case-by-case basis, if a company you owned cut its dividend, that would not be an automatic sell?

Simon Gergel: No, not necessarily. I mean, we bought, for example, Burberry Group (LSE:BRBY), which very soon after we bought it, we knew the company had trouble. The share price had come down a long way before we bought it. They actually changed the chief executive and cut the dividend. We bought more shares because we saw the potential in the business and we saw what the new chief executive was doing.

So, absolutely not. It’s about trying to make money on each share. And, overall, the portfolio has a good yield. Does every single holding in a portfolio need to pay a dividend? When we invest, we look for companies which have a yield close to the market or above, either today or within the foreseeable future. But if a company cuts the dividend, we won’t automatically sell it. We will take a different view. We’re much more pragmatic. If we own a company and we might, like with Burberry, buy more.

Kyle Caldwell: Within the medium-sized and smaller-sized companies, where you’ve been finding more opportunities than usual, does this stem from the fact that the (higher than usual) average dividend yield you can get in that part of the market, earlier this year it became higher than the large company part of market for the first time in, I think, about 20 years?

Simon Gergel: That’s right. It hasn’t happened in a generation almost. The yield on the mid-cap index is higher than the large companies. It’s very unusual because mid-caps companies tend to have higher growth and tend to be a bit more dynamic, and they tend to therefore be more expensively rated, or higher priced, with a low yield. That has reversed.

That’s not why we’re buying mid-caps, but we’re finding many opportunities because that mid-cap area has been so out of favour, we’re finding lots of opportunities to buy really good companies at what we think are excellent prices. So yes, I don’t like this phrase, but we are leaning into that part of the market where we are finding mid-cap companies with good yields and attractive fundamentals.

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Kyle Caldwell: Could you highlight a couple of examples of companies in that area that you’ve either added to or introduced as new holdings?

Simon Gergel: Yeah, so we bought a company called RS Group (LSE:RS1), which is an international distributor of components, all sorts of products that people need for actually keeping factories running and keeping industries going, and also for design engineers. A lot of people know the RS catalogue as old. That’s an interesting business that has been significantly derated.

Another one you probably know quite well is a company like MoneySuperMarket (which trades as Mony Group (LSE:MONY)), which owns MoneySavingExpert. That is a comparison website. That company, again, has been out of favour because there’s been some challenges in [that] industry. It’s brought the shares down to what we think is a very compelling valuation. So, there’s just been a number of different opportunities in that area.

Kyle Caldwell: When investing in this area of the market, how much are you thinking about how economically sensitive a business is? As, of course, companies outside the FTSE 100 index are typically more domestically focused.

Simon Gergel: Yes, they are typically more domestic and typically more cyclical, not in every case, of course. When we think about that, we think of the overall portfolio and ask how much exposure we have got in aggregate to areas like the domestic economy, like the UK versus international. And it’s true that we have, as we’ve been buying mid-caps, we’ve being going more into those areas.

But we think many of those areas are really interesting. Take the housing market in the UK, very depressed, activity’s low, but the government is determined to increase housebuilding in the UK. And all the companies associated with that would benefit from a recovery in due course when that happens and valuations are very low. So, we are taking advantage of those opportunities and, yeah, we’ve got a bit more in that area than we had previously.

Kyle Caldwell: You’ve mentioned housebuilders. Could you run through the exposure you have to that sector?

Simon Gergel: Well, of the direct house builders, we own Bellway (LSE:BWY) and Barratt Redrow (LSE:BTRW). We used to own Redrow, but that’s been taken over by Barratts, We own building materials distribution companies like Grafton Group Units (LSE:GFTU) and Marshalls (LSE:MSLH), which makes roof tiles and paving stones. We own Norcros (LSE:NXR), which makes taps, showers and shower fittings.

So, we own a whole raft of companies in that area to get a broad range of exposures, and also some of the aggregate companies that dig up aggregates and make cement and so on.

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Kyle Caldwell: And could you highlight other areas of the UK market where you’re finding high-yielding opportunities?

Simon Gergel: Well, it’s quite a wide range. So, the very highest yields we’ve got [include] Legal & General Group (LSE:LGEN), which is a life insurance company, and pays something like an 8% dividend yield, and has a good record of growing that dividend over time.

At the other end, we’ve a very small company called Duke Capital Ltd (LSE:DUKE), which provides finance to small businesses - that actually pays a 10% yield.

Then in the middle, we’ve got a company like Energean (LSE:ENOG), which is mainly gas, but a bit of oil, company in the Mediterranean. That has very long-term contracts to sell its product at favourable prices and so it’s got a very secure earning stream and that also has a very high dividend yield.

Kyle Caldwell: Simon, thank you for your time today.

Simon Gergel: Thank you.

Kyle Caldwell: And that’s it for our latest Insider Interview. For more videos in the series, do hit that subscribe button and hopefully I’ll see you again next time.