Last month saw the sharpest ever reported contraction in the British economy, with a 20% fall in monthly gross domestic product (GDP) recorded for April, due to the government’s lockdown measures to control the coronavirus pandemic. However, investor attention seemed more focused on the gradual lifting of restrictions on most retailers in June and air travel, restaurants and pubs from July. There were positive developments in the UK and across much of Europe as the rate of reported Covid-19 infections and deaths declined significantly over the month. However, the trend was more concerning in the USA, where contagion was accelerating in certain large states, such as California and Florida.

Stock markets were supported by optimism over easing lockdown restrictions, low interest rates and government stimulus packages, recording a small positive return for the month. This took the UK market’s total return for the quarter to over 10%, one of the strongest returns in the last decade, whilst the US stock market and European indices returned high teens percentage gains or better.

The volatility and divergence within the UK market was not as extreme as in the last few months, but there were still some notable sector moves. The strongest sectors included life insurance, utilities and mining, whilst the weakest included healthcare equipment, travel & leisure and beverages.

Portfolio performance was marginally behind the FTSE All-Share benchmark in June. The NAV returned 1.4%, also marginally behind the 1.5% return of the benchmark. Strong performers included double digit share price total returns at recruitment company SThree, which reported more resilient demand than expected for temporary workers in specialist STEM areas, SSE which met market expectations for its final dividend, and Legal & General which was supported by rising markets. On the other hand, Landsec was weak on general concerns about the real estate market, especially retail property. Man Group pulled back in response to weak performance in some of their investment funds. Also, Redrow shares fell back at the end of the month as a trading update included a write-down of assets in London, as the company scales down its homebuilding operations in the capital.

We made a modest new investment into retailer Next Plc. Next has migrated the business successfully from predominantly shop and catalogue based retailing towards online, whilst broadening the product range and earning consistently high returns and strong cash flows. Whilst current trading is under huge pressure from the lockdown and social distancing, Next has reacted in its characteristically decisive way to protect its financial position and reposition for the future. Although the business cancelled its recent dividend, we would expect Next’s historically strong cash flow to recover, in the medium term, and for ordinary and possibly special dividends to resume.

We also added to National Grid and SSE, two large UK utilities which reaffirmed their attractive dividend policies in June. Both companies are investing significant amounts into their growing infrastructure businesses, and exploiting rising demand for renewable power generation, whilst they are well placed to benefit from any “green recovery” investment plans backed by the government. Although both are exposed to an element of regulatory risk, regulators also need to help facilitate a transition to cleaner energy, which requires substantial investment over very long time scales.

These investments were financed primarily from taking profits on shares that had outperformed in recent months and offered lower upside potential, such as the building materials and construction firms CRH and Balfour Beatty, and gambling company GVC. We also reduced holdings in the banks sector to reinvest into Next where we have higher conviction.

Investment markets are being heavily influenced by cheap money and stimulus from central banks. These money flows are also influencing share prices, with more dependable, higher quality or growth stocks finding particular favour. A small group of very large US technology stocks, which are relatively resilient to the impact of the Covid-19 pandemic, have driven the technology heavy Nasdaq index to record highs, despite the continuing health and economic problems in that country. In the UK we have also seen certain company share prices appreciate to high valuations, which we find hard to justify in many cases. However, the picture is not uniform. According to Morgan Stanley, the valuation gap between UK “value” and “growth” companies is the widest in 45 years, whilst the UK market is as lowly valued compared to the world index as it has been over that entire period. By implication, therefore, UK ”value” shares offer an extraordinary valuation opportunity compared to broader equity markets.

Anecdotally we see this dispersion of opportunities when we look at individual companies. There are many fundamentally sound businesses, trading on really attractive valuations, which we believe are likely to be re-rated as the economy recovers from its period of forced shut-down. Whilst we are maintaining a balance in the investment portfolio, with a combination of more cyclical and more defensive businesses, the average valuation of the companies owned by Merchants is significantly below the average for the broader UK market.