How this dividend hero delivers a market-beating yield

In the second part of this Insider Interview, manager Simon Gergel explains how he divides The Merchants Trust Ord (LSE:MRCH) into different types of value stocks to deliver a diversified portfolio with a market-beating yield.

Gergel also explains why financials is a key sector focus, and runs through how he’s approached the recent uptick in volatility amid the ongoing conflict in the Middle East. 

He also addresses why performance has lagged the UK market over three and five years, details the dividend reserves that can be drawn on in future, and talks about opportunities he’s finding among some historically highly rated businesses that now have cheaper price tags.

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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: So, Simon, at the time of this recording, the conflict in the Middle East is ongoing. As a fund manager, how have you been approaching the uptick in stock market volatility?

Simon Gergel: Yeah, well, we’ve had a lot of volatile periods in the last few years, whether it’s Covid, or the global financial crisis. I think it’s very important as an investor to step back and say, what are we doing? We’re trying to buy individual companies that we think are cheap on a long-term basis. It’s quite dangerous, or it’s risky, to throw around the portfolio, to make big changes in the face of quite uncertain events. So, we haven’t made dramatic changes to the portfolio.

We’ve clearly thought about individual companies and the impact, but it’s hard to know genuinely whether the issues are going to be transitory or permanent or sustained for a long period of time. So, we look very much at individual companies and if we can convince ourselves, or if we believe, that each individual company is a sensible investment at the time, there’s no reason to make major changes to the portfolio.

Kyle Caldwell: And during such periods, is it a case of trying to not make changes as well as thinking about what to do?

Simon Gergel: Not necessarily because the dislocation in the market, the movements, can create opportunities both to buy companies that you haven’t had a chance to buy before because there are more interesting valuations, and sometimes to sell companies because maybe they get a safe-haven status and they moved to too high a valuation.

So, we may take advantage of the volatility, but we won’t generally make massive changes early on in a situation like this which is evolving rapidly.

Kyle Caldwell: Merchants Trust has a notably higher dividend yield than the wider market, the FTSE All-Share index. However, in total return terms, over both three years and five years, you have underperformed that index. Could you explain why?

Simon Gergel: Yes, I mean, the last two or three years have been quite challenging for our type of value investing. We have found a lot of opportunities to invest, particularly in the medium-sized companies, and particularly in domestic areas. And those areas have been out of favour with investors.

The economy hasn’t really recovered. And therefore, we’ve seen those companies get cheaper and cheaper to some extent. And the market’s been driven very much by particular themes, whether that’s in the banks sector, or the strength of aerospace and defence. We’ve benefited from those themes to some extent, but we’ve not kept up with the really strong market returns in the last couple of years.

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Kyle Caldwell: You’ve mentioned financials, which is a key area of the portfolio. Could you talk us through your current exposure and run through your latest thoughts on the banking exposure, given that that part of the sector has had a very strong run over the past year?

Simon Gergel: Yeah, well the banks have performed very well over the last year or two, and we’ve taken some of the positions down a bit to take some profits on those, but they still look decent value.

But we’ve also got a lot of exposure to insurance, whether that’s life insurance like Legal & General Group (LSE:LGEN), some of the re-insurance companies, and also some of those specialist financial companies like Man Group (LSE:EMG), which is an asset manager, or IG Group Holdings (LSE:IGG), a trading business.

There’s a lot of different opportunities, and we like to have a diversified portfolio, so we’re not putting all our eggs in one basket. We’re not just investing in one theme or one sector.

Kyle Caldwell: You’ve spoken before about dividing the portfolio into classic value, franchise investments, and special situations. Could you talk through each of those, and could you outline some stocks that fall into those three buckets?

Simon Gergel: Yes, so the thinking behind that is there are some companies that aren’t really growing much. Some industries like oil and gas or, actually, banking typically doesn’t grow that much. But companies can get very cheap from time to time. If we can take advantage of that, we call those classic value, we buy them very cheaply, but we’re very disciplined about the price at which we will sell them again.

There are other businesses which are growing over time and creating value. They’re earning a return above their cost of capital. Typically they are strong franchises in attractive industries. Those businesses, the fair value of the business is growing over time. And so yes, we want to buy them cheaply, but we may run those positions a little bit longer around about fair value because they’re growing, their intrinsic value is growing all the time.

The third are special situations, which by definition are quite unusual. They come up from time to time. At the moment, the portfolio is pretty evenly split between that classic value and the franchise, and we’ve got virtually nothing in the special situations.

Kyle Caldwell: And have you been looking at some of the more classic, quality growth stocks that have fallen out of favour over the past couple of years? I’m thinking of things like Diageo (LSE:DGE), for example.

Simon Gergel: Yeah, I mean, we always look at those types of companies and very often we are buying companies that have fallen out [of favour]. So, in the last year, a couple we bought include Whitbread (LSE:WTB), which owns Premier Inn, and has typically historically been quite a highly rated business.

We bought Hikma Pharmaceuticals (LSE:HIK), which again has got a really good long-term growth record, and we bought Reckitt Benckiser Group (LSE:RKT), or Reckitt as it’s called now. It is a consumer staples business, which, again, has derated.

So, yes, absolutely, we’re looking to take advantage of some of those companies where we’re confident that the business is fundamentally sound and valuations are attractive.

Kyle Caldwell: For an investor who simply bought the UK market via an index fund or an exchange-traded fund (ETF), they’ve done very well over the past couple of years. Could you make the case for backing an active fund manager like yourself over the long term, as opposed to just simply owning the index? 

Simon Gergel: Well, I think investors have to be comfortable with what they are doing and what they are investing in. What we’re offering and what we’re trying to do is deliver a high, significant premium income and a growing income that has grown every year for 44 years. 

Second, it is quite a concentrated, actively driven stock-selection approach. So, our portfolio is very different to the benchmark, to the index, and we’ve put lot of money where we see really excellent value. Our returns will therefore be different from the index. 

So, if you think that a value investment approach, i.e. buying companies when they are cheaper than where they normally trade, is an interesting, attractive philosophy, and if you are looking for a higher income than the overall market, that might appeal to you. But each investor has to think about what they’re comfortable doing.

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Kyle Caldwell: Despite the fact that the UK market outperformed the US market last year, we’re still seeing fairly low sentiment towards investing in the UK. What do you think needs to happen for that to pick up? 

Simon Gergel: Yeah, I mean, that’s the multi-million dollar question, isn’t it? I think it’s been extraordinary how strong the UK market’s been and how little commentary there’s been about that, because the UK has outperformed significantly America and, actually, much of Europe in the last year or two. I think it becomes self-fulfilling at some point. If the UK can continue to outperform, at some [point] people will start to realise and notice that. 

On top of that, what you are seeing is a lot of takeover activity in the UK, because the market’s so cheap. A lot of buybacks, something like £45-£50 billion a year of buyback in the UK. So, if you stop seeing people selling the UK, the market will almost certainly - or should - go up because of all that pressure of people buying and takeovers. So, at some point it should correct, i.e. people should get more excited about the UK, but it’s very hard to say what’s going to change the narrative. 

The media seems to focus on the negatives about the UK, whereas I think there are lots of challenges elsewhere in the world, whether it’s politics or economic issues, and the UK doesn’t look that different when we look at it [compared] to many other countries. In some ways, it is more attractive, certainly on valuations. 

Kyle Caldwell: You’ve mentioned that Merchants Trust has a long-standing dividend track record. It has increased its dividend every year for 44 years. How important is maintaining that dividend track record, and could you run through the strength of the revenue reserves that you can dip into if there’s an income shortfall? 

Simon Gergel: Yeah, and that’s a great question. It’s a really key objective of the trust and the board of directors who hold us to account. We look at it and the board looks at it at every board meeting, the income trajectory and how it’s shaping up. 

The dividend is covered by earnings, fully covered, and has been for the last three years. We’re not one of those trusts that’s been paying dividends out of capital. It’s fully paid out of earnings, or of retained earnings in previous years as reserves. 

Reserves are very significant. They’re about 60% to 70% of a full year’s dividend, so they are very substantial. The income trajectory of the portfolio looks good at the moment. Many companies, because they are paying special dividends, because they are doing buybacks, their dividends are often very well covered. So, when we look at it, we feel pretty good about the income outlook at the moment.

Kyle Caldwell: Another tool that investment trusts have is the ability to gear. Could you run through your approach to gearing and what the current gearing levels are? 

Simon Gergel: Yeah, so Merchants Trust has some long-term borrowings, it’s about 12% to 13% at the moment. 

The idea behind that is if our average cost of debt is about 5.2%, if you could borrow money at 5.2% and make a higher return than that in the market, then you’re adding value for shareholders. 

At the time, the dividend yield on the portfolio [was] nearly 5%. So, we need very little capital growth on top of the dividend to make that accretive. So, gearing to a modest and conservative level makes a lot of sense for long-term investment trusts that [have] permanent capital. 

Kyle Caldwell: And, Simon, the last question we ask every fund manager is, do you have skin in the game? 

Simon Gergel: Yes, I’ve got significant investment in Merchants Trust, actually on your platform, so thank you for that. 

Kyle Caldwell: It’s great to hear that you’re an interactive investor customer, and thank you for your time today. 

Simon Gergel: Thank you.

Kyle Caldwell: 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.