February saw a continuation of January’s stock market recovery, after a tough end to 2018. Sentiment was helped by increasing hopes of a resolution of the trade tensions between the USA and China. In the UK, the prime minister Theresa May hinted for the first time, that there could be an extension to “Article 50”, delaying the UK’s exit from the European Union, and making a “no-deal” exit less likely.

The stock market produced a total return of just over 2%, with many companies reporting their 2018 results. In general, cyclical and financial sectors were the strongest performers, including construction & materials, insurance and general retail, although pharmaceuticals also outperformed. The weakest large sectors were defensive industries, like telecommunications and food producers.

The Trust’s NAV rose by 3.3% over the month, with performance modestly ahead of the FTSE All-Share benchmark, which rose by 2.3%. The biggest positive stock contributors to relative performance were SThree, Greene King and Legal & General. The biggest negative contributions came from BAE Systems, IG Group and from not owning AstraZeneca, which rallied and helped the overall index performance.

We have a strict discipline to review a holding in the portfolio if the investment case changes. In February, we reviewed the case for Marks & Spencer, on new information. Our investment case on M&S had been based upon the company enacting a major restructuring of the business, making profound changes to their store estate and their clothing & home proposition, and growing their online presence. We expected this to be supported by strong underlying cash generation, particularly from their food and international businesses, which would allow the company to restructure, whilst still paying a high dividend to shareholders. We believed that M&S’s strength in food is driven by a differentiated offering, especially targeted at a growing convenience channel.

It became clear in recent weeks, with widely published rumours of M&S’s interest in working with Ocado, that the company was considering a significant push into online food delivery. This suggested that the management’s view of the strength of M&S’s food offering was more related to the large “weekly” shop, rather than the convenience or “buy for tonight” shop. Not only do we see this area as more competitive, but we were concerned about a number of significant risks to a potential tie up. In particular, the average M&S food basket size tend to be small, so not well suited to online shopping, and there could be cannibalisation of in-store sales, if M&S shoppers shift their purchasing to Ocado. Also, we were concerned that any deal could consume a significant amount of cash, reduce future cash flow and threaten the dividend payments. We therefore decided to sell the shareholding.

Later in the month, M&S announced its intention to spend up to £750m on a joint venture with Ocado, to raise £600m in a rights issue and to cut the dividend by 40%. It is a complex deal, in which M&S is not acquiring many assets, and it will be many years before we will be able to judge if this is the right strategy for the group.

Apart from this transaction, the main activity was to add to existing investments at attractive valuations, taking advantage of recent volatility in the market. This included increasing the holdings in WPP and BAE Systems.

This is a favourable environment for active investors, after a period of some volatility in markets. We can identify many strong businesses, trading on unusually attractive valuations, which should, in the medium term, deliver a high and growing income and good total returns, in line with Merchants’ objectives. Uncertainty over the outlook for economies and markets, makes it important to diversify the portfolio, and to pay close attention to balance sheet risks, economic sensitivity and structural concerns at the individual company level.

The portfolio is positioned very differently to the overall stock market. There are large positions in industrial sectors like aerospace & defence and construction & building materials and consumer sectors like travel & leisure and media. Less economically sensitive exposures, include positions in modestly priced tobacco stocks, utilities and pharmaceuticals. Among the financial sectors, we have a preference for life insurance, real estate and general financial stocks, with more modest exposure to banks, which are more sensitive to any weakness in the domestic economy. Elsewhere, Merchants owns several mining and oil companies, which offer solid value and attractive cash flows and dividends.