Merchants Trust: the income stocks we’ve been buying and selling

Investing in high-yielding UK shares, Merchants Trust (LSE:MRCH) is a popular choice for income investors. Managed by Simon Gergel, it has racked up 41 consecutive dividend increases, and the trust has no intention of breaking its record. 

Gergel speaks to interactive investor’s Sam Benstead about the income stocks he’s been buying and selling this year, and goes into depth about why the UK is a great market to hunt for income shares at the moment. 

He also reveals the shares and sectors he thinks the market is overlooking, which have high yields and are in a strong financial position.

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Simon Gergel, manager of the Merchants Trust. Simon, thank you very much for coming into the studio.

Simon Gergel, manager of Merchants Trust:Hello.

Sam Benstead: It's been a volatile start to the year. We've seen interest rates hit 5% in the UK and lots of worries about the economic outlook. So, how have you been managing the portfolio? What have you been buying and selling?

Simon Gergel: Well, it's been yet another volatile period in markets, as you hint. And one of the flip sides of that volatility, one of the benefits of the volatility as an investor, is that it throws up opportunities. So first, the UK stock market is quite cheap compared to its history and compared to other markets. And second, within the market there's a huge dispersion of valuations. So there are some companies on quite high multiples and many others that are really cheap compared to history, and that's throwing up lots of opportunities for stock pickers like us.

So, we found a number of companies, often in the more cyclical areas and the more mid-cap areas, that's where we're finding the best opportunities at the moment, because the larger companies tend to have more of a following. One of the other things that's happened is you've had money going out of the market. People have been selling, which has again put pressure, particularly on domestic companies.

Sam Benstead:And can you give some examples of companies that you've bought this year and companies that you've sold this year?

Simon Gergel: Yes. A company that we bought earlier in the year was Pets at Home (LSE:PETS), which is well known as the UK's leading retailer of pet products, accessories and food. But they also run a vet business called Vets for Pets, which is a joint venture. And that combination of businesses is really powerful. It was one of those businesses that was quite depressed in the stock market because people were concerned about the outlook for retail spending. But actually people spending on pets tends to be very resilient. People will prioritise pets a lot above many other areas. And also over time, people are spending more and more on their pets, giving them better healthcare, better food, better nutrition, treating them more as members of the family. So, you see these quite powerful long-term trends. We see that business as quite well positioned in the medium term and not a cyclical, as the market was implying. And we saw a good opportunity earlier in the year to buy that business at a sensible price at that time.

In terms of selling, we had a company called BAE Systems (LSE:BA.), which is the UK's largest defence company. In fact, the UK's largest manufacturing business, but it also has a really strong presence in America and elsewhere. It's been a really successful investment for us over the last two or three years. Clearly, defence spending is going up significantly, partly because of the troubles in Ukraine, and that's led to a rerating of the shares and they've moved from being quite modestly priced to being, in our view, quite fully priced, or at least we no longer saw much upside. We're quite disciplined on valuation and so we sold that to fund some other areas.

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Sam Benstead: You said there that the UK is very cheap at the moment. Can we put some numbers on that? How does that compare to say, US or global shares, and what's the reason it's cheap, and what could be the catalyst for it becoming more fairly priced?

Simon Gergel: The UK market is trading at about 10 times price-to-earnings ratio, which means you pay £10 for every £1 of profit and that's a substantial discount, something like 40% discount to the global average. The US would be at the higher end and Europe at the lower end. What's driving that? A number of things. I think ever since the Brexit referendum there's been a bit of uncertainty about the UK, particularly from foreign investors.

There's been political uncertainty, although we think that should become less of a feature going forwards because, Rishi Sunak and Keir Starmer, who might become the next prime minister, their policies aren't a million miles away from each other in the way that maybe Boris Johnson and Jeremy Corbyn's policies were a few years ago. So, I think the political risk has been one factor keeping people out of the UK.

I think the other thing is that there's been a concern since Brexit about how the UK economy would fare and actually it is not doing that much worse than other economies. Unemployment's remained quite low. The economy's trundled along, it has not been high growth, but it's been OK. So, I think those have been two of the main features in the UK market to depress sentiment. And then we've just had a lot of selling by institutions, pension funds, insurance companies, but also individuals, which has just led the UK to be even cheaper, and out of favour. But I think all that is an opportunity.

I suppose the other final thing is that Covid hit the UK pretty hard, just as we were coming out of the uncertainty after Brexit, Covid came along. So there's been a succession of issues that have hit the UK and [made] many people cautious, but many of those are working through the system now and should gradually reverse hopefully.

Sam Benstead: The trust yields 5% and you fish in the higher-yielding pool of shares in the UK markets. Are there any high-yielding shares that you'd like and think pay a stable dividend, but the market is perhaps a bit more worried about?

Simon Gergel: There are quite a number. If you look at the energy companies, they've got high yields, but really strong cash flows. The banks, having been through 15 years of a difficult period, with a succession of things they had to do, [including] rebuilding their balance sheets, taking the leverage down, [and] debt down in the system. They had to pay lots of money for PPI claims, you probably remember, and also pension funds. There were lots of calls on the cash of the banks, which meant that although they were generating profits, a lot of that was being absorbed. They're now generating lots of surplus cash. They're starting to pay significant dividends and buying back shares. And with interest rates rising, that’s generally quite positive for the banks. So, that’s an industry where you’ve got very high yields and we think those are sustainable. But there’s many other individual companies in the medium-sized area that are good businesses with strong business models, sound balance sheets, where dividends do look pretty resilient.

Sam Benstead: Can you give some examples of those under-the-radar dividend payers, which investors might not have heard of but actually present really good income investing opportunities?

Simon Gergel:We’ve got a company called Inchcape (LSE:INCH), which is a car distribution company. Quite an unusual business, and what they do is they are effectively the manufacturer’s agent in certain markets. So, for example, Inchcape has been looking after Toyota in Hong Kong for 50 years. They are effectively Toyota in Hong Kong. They bring the cars into the market, they provide them to the retailers, they work with the aftermarket spare parts and they work in over 40 countries for a large number of different brands. Half their business is now in Latin America.

This is quite a diversified business and these relationships are really powerful. Once a manufacturer, a brand, uses you in one of their markets, they tend to stick with you. It tends to be quite resilient. It’s not like car retail where the profits go up and down a lot. Distributing cars, you’re taking a fee on bringing the car in and all the services you’re providing, it’s a good margin business, it’s quite profitable. And they are generating a decent amount of cash, paying a dividend, which we believe should be sustainable. You never quite know in investment, there’s always things that can happen. But that is an example of a business that isn’t that well known but is actually a market leader in what it does, it’s the leading company in that industry, but it’s listed in the UK, but it's a global business. A very small amount of its sales and profits are coming from the UK.

​​​​​​​Sam Benstead:And what’s the yield on that at the moment, more or less?

Simon Gergel:It’s around about 5%.

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​​​​​​​Sam Benstead: Gearing is a feature of investment trusts, it allows you to borrow to increase returns. So, what is the gearing in the trust today? And what is the policy around gearing?

Simon Gergel: So the simple idea is if you can borrow money and get a better total return from the investments you make than the cost of that borrowing, then you can enhance the returns you make for shareholders over time. And so we have a modest amount of gearing or borrowing. The borrowing in Merchants is about 14% of the net assets. We have a range of 10% to 25% at the time we draw down debt and the gearing is a decision for the board.

It's probably worth saying that investment trusts have independent boards of directors, separate from the manager, who make decisions about issues like gearing, but they're comfortable with 14% gearing, which will hopefully enhance returns. It also allows us, because of some technicalities, to pay a slightly higher income to shareholders. But, of course, it also adds to volatility. So where markets go up, gearing should help accentuate those returns. But clearly if markets go down, gearing can amplify those returns on the downside as well. So investors need to understand with investment trusts that if you have gearing, it can amplify returns in both directions. Our cost of debt is 4.5%. If we can make more than 4.5% in the long term on the portfolio, then the gearing should be beneficial to shareholders.

​​​​​​​Sam Benstead: Do you think the role of gearing will change now that interest rates have risen so much? Because you have to make more money when you invest the money that you borrow, or do you not see that moving too much?

Simon Gergel:It might change over time. Two-thirds of our debt is fixed rate, so we've got a 30-year bond with a 3.5% coupon. Our average cost is 4.5%. It's gone up a little bit because some of our debt is floating, but most of it is fixed and therefore it's going to take a long time for rising interest rates to feed through because we've got one bond, which is in 2029 and one in 2052. So it's really going to take a while to have an impact. But yes, at the margin, you might find that investment companies borrowing money on floating rates might take a different view on gearing over time.

​​​​​​​Sam Benstead:And finally, the question we ask all our guests, do you personally invest in the trust?

Simon Gergel:I do. I've got a significant amount of my own money in the trust and the other funds that I manage.

​​​​​​​Sam Benstead:Simon, thank you very much for coming into the studio.

Simon Gergel:Thank very much.

​​​​​​​Sam Benstead:And that's all we've got time for. You can check out more Insider Interviews on our YouTube channel where you can like, comment and subscribe. See you next time.