Investors were nervous in October as a second wave of rising cases of Covid-19 in Europe led to regional and in some cases national lockdowns, although these were generally not as stringent as measures taken earlier in the year. There was also continuing uncertainty about the forthcoming US presidential elections and the Brexit negotiations between the UK and EU, which continued past a self-imposed UK deadline in the middle of the month.

Most stock markets produced negative single digit total returns. The UK stock market, as measured by the FTSE All-Share index returned -3.8%, although medium and smaller sized companies outperformed. The falling stock market was led down, somewhat surprisingly, by several of the more defensive sectors, such as food producers, tobacco and pharmaceuticals, although life insurance shares also underperformed. The strongest performing sectors produced positive returns and included cyclical sectors like banks and industrial engineering, as well as the more defensive utility and telecommunications sectors.

Portfolio performance was ahead of the benchmark with the Trust’s NAV return for the month also ahead at -0.8%. The three biggest positive contributions to outperformance were companies that announced results or trading updates in the month. Tyman and DFS, where share prices rose around 20% in the month, are both seen as benefitting from people spending more time at home during the pandemic. There has been a strong recovery in demand for both new homes and home improvements, which benefits Tyman’s window and door components businesses, whilst strong demand for sofas has led to strong growth for UK market leader DFS in the early months of their new financial year. Barclays share price also responded well to results, which showed growth in their investment bank and a reduction in the bad debt charge compared to the previous quarter.

On the other hand, the biggest negative impact on relative performance came from weak share prices of economically defensive businesses, like BAE Systems and Imperial Brands, as well from not owning HSBC, as those shares rallied along with the sector.

We added to two financial investments that we initiated in September, Close Brothers and RSA Insurance. These were financed partly by selling the remaining small position in NatWest and reducing property company Landsec, where we had a lower level of conviction.

We also added selectively to large, high yielding companies that were lowly valued such as BP, Vodafone, SSE and GlaxoSmithKline. These investments were financed by selling the remaining position in water utility Pennon, which had performed extremely strongly and became fully valued after announcing the sale of its Viridor waste business for a high price. Finally, we took some profits after gains in Tyman, Stock Spirits, IG Group and PZ Cussons.

As we look forward, there are uncertainties around US policy following the election and continuing UK / EU trade negotiations. But, the course of the coronavirus pandemic is likely to remain the biggest short term issue for stock market investors torn between the economic damage of further restrictions to movement and activity on the one hand and hopes for recovery driven by vaccines, better treatments and effective tracking on the other. At present, restrictions are less onerous than earlier in the year allowing most manufacturing and some service industries to operate effectively, including education, housebuilding and home improvements. Whereas other industries remain severely impacted, including aviation, transportation and leisure.

Uncertainty over the shape and pace of economic recovery is exacerbating the polarisation of the stock market. There are extremely high valuations placed on being in certain businesses offering more reliable growth or making strong returns on capital employed, whilst many other businesses trade on very low valuations. The Merchants Trust has a strong bias towards cheaper stocks, with the average valuation of portfolio companies at a significant discount to the broader market. We believe these companies can offer a combination of an attractive dividend yield and strong total returns in the medium term. It is worth noting that the portfolio also has a balance between defensive and cyclical or financial companies, reflecting attractive investment opportunities in both of these areas, and continuing uncertainty over the outlook.