Fund Manager Comment

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Simon Gergel
Fund Manager

As the UK general election campaign moved up to full speed, Theresa May tried to convince the electorate that the Conservatives would provide a “strong and stable” government, even as she had to make an embarrassing change to a manifesto policy on social care funding. The Conservatives lead over Labour in the polls narrowed significantly during the month.
Equity markets were strong and (relatively) stable over the month, with extremely low volatility, despite a downward revision to the UK’s first quarter economic growth rate to only 0.2%. Emmanuel Macron won the French presidential election, which helped sentiment, at a time when European economic growth seemed to be accelerating.

The best performing sectors in May were defensive areas such as mobile telecommunications, personal goods, utilities and healthcare, whilst the weakest sectors included cyclicals such as oil equipment & services, mining and industrial engineering.
The Trust’s NAV rose by 3.7% over the month, slightly behind the FTSE All-Share Index benchmark return of 4.4%. The biggest positive stock contributions to the relative return came from good performance at GlaxoSmithKline, and not owning Glencore or Imperial Brands, which were both weak. The biggest negative contributions were from Kier and Ladbrokes, which underperformed, and from not owning Vodafone, which rallied.
There was a relatively high level of activity within the month, in response to recent share price movements, which created a number of investment opportunities. We built a new position in WPP, a global media business with a broad spread of activities. The company has a leading position in the faster growing digital and new media sectors, as well as in emerging markets. Recent underperformance, in response to disappointing trading updates, had brought the valuation down to an attractive level, which does not reflect the growth potential, in our view.
In contrast, we sold the remaining small position in British American Tobacco, leaving Merchants with no tobacco exposure for the first time in many years. BAT has been a very strong performer and is now highly valued on almost any measure. The industry faces unprecedented change, with healthier e-cigarettes and next generation tobacco products disrupting the traditional cigarette business. Whilst these innovations are not necessarily negative for the companies, the outlook is more unpredictable than in recent years, and both the large UK tobacco companies carry considerable debt on their balance sheets.
It is instructive to compare the valuations of these two companies, as it demonstrates the premium that stock market investors are today willing to pay for companies with perceived security and stability, compared to companies with more cyclical risks. For many years, BAT was a lowly rated company. However, taking Bloomberg consensus forecast forecasts as at 6 June, BAT is trading on a 20x price to earnings ratio versus 14x at WPP. On an EV/EBITDA1 (a cash flow ratio used to measure the value of a company) BAT trades at 17x versus 10x at WPP. And BAT offers a lower dividend yield of 3.3% versus 3.6% at WPP.
Elsewhere, we sold the remaining position in Hostelworld, as it reached a full valuation and we took profits on several strong performing companies, including FirstGroup, NEX Group, Tate & Lyle, Senior and National Grid. The proceeds were reinvested into the engineering companies Meggitt and Morgan Advanced Materials, as well as National Express, all of which we believe offer good value. We also added to the mining company, BHP Billiton, which has an attractive mix of assets and improving cash flow, as capital expenditure is reduced.
Speculation in the run-up to the UK General Election raised short term uncertainty about the political leadership in the UK and economic policy as we enter critical Brexit negotiations. However, ultimately, share prices will reflect long term prospects for economic growth and corporate profitability, which may not be significantly impacted. Furthermore, the UK stock market is heavily exposed to multinational companies which are less exposed to domestic issues and benefit from any sterling weakness. Whilst there are risks, we can find many attractive investments in sensibly valued UK companies that offer exposure to a diverse range of industries and geographies, which benefit from the UK’s leading standards of corporate governance and regulation.
1. Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortisation
Data as at 31.05.2017

Simon Gergel
Fund Manager, The Merchants Trust PLC

The information contained herein including any expression of opinion is for information purposes only and is given on the understanding that it is not a recommendation and anyone who acts on it, or changes their opinion thereon, does so entirely at their own risk. The opinions expressed are based on information which we believe to be accurate and reliable, however, these opinions may change without notice. This is no recommendation or solicitation to buy or sell any particular security. A security mentioned as example above will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date. Past performance is not a reliable indicator of future performance. You should not make any assumptions on the future on the basis of performance information. The value of an investment and the income from it can fall as well as rise as a result of market fluctuations and you may not get back the amount originally invested.

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Simon Gergel
Fund Manager

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