The stock market continued to react to the spread of the coronavirus pandemic and the economic implications. Although the spread of the virus through North and South America was a concern, investor attention turned towards the gradual easing of lockdown restrictions in much of Europe and the UK. The stock market was relatively firm in the second half of May, with the FTSE All-Share index ending the month up 3.4%, with single digit gains in most international markets.

Apart from the coronavirus news, the Chinese government announced a new national security law for Hong Kong outlawing acts such as sedition and subversion. This raised fears that it could lead to the end of the one country two system status of Hong Kong that has existed since the British handover in 1997. The Hong Kong stock market fell heavily.

Within the UK, there was quite a wide variation of sector performances, with pressure on the sectors most affected by COVID-19 effects for much of the month, reversing sharply in the last week on hopes around the easing of lockdown restrictions. The best performing sectors included mobile telecommunications, reacting to robust results and a maintained dividend at Vodafone, as well as cyclical sectors like mining and general retail. The worst sectors included banks with HSBC falling by 10% on Hong Kong fears, aerospace & defence, and more defensive sectors like food producers and utilities.

The portfolio lagged behind the market return, but with a strong end to the month as sentiment towards the more depressed and lower valued companies improved. The biggest impact to performance came from Imperial Brands, which reported weaker than expected results and a widely anticipated one third cut to the dividend. National Express was also weak as the company carried out a large equity issue and real estate company Landsec also declined as results highlighted continued pressure on asset values, especially in the retail sector. Against this backdrop the Trust’s NAV returned 1.9% in May, lagging the 3.4% return of the market.

On the other hand, strong results from Stock Spirits lifted the share price by 30%, whilst Standard Life Aberdeen and BHP Billiton both produced double digit returns. Not owning HSBC also helped relative performance significantly, given the weakness in the share price.

We have had limited exposure to large UK telecommunications companies in the last few years. For most of that period the sector has been a value trap, with attractive looking valuations being repeatedly undermined by deteriorating industry fundamentals, caused by intense competition, regulatory interventions, such as ending mobile roaming charges within the EU, rising spectrum costs and other factors. We are starting to see fundamentals improve. Governments and regulators are keen to encourage investment in fibre networks and they are adjusting regulatory frameworks, companies are sharing infrastructure, such as mobile phone masts, and we are seeing greater consolidation. We have become more positive on the prospects for UK telcos in recent weeks. Share prices fell sharply in the first quarter of 2020 taking valuations to more attractive levels and despite telecommunications revenues being far more resilient than many other sectors to the economic impacts of the coronavirus pandemic. In March we made a new investment in BT and this month we bought Vodafone.

Vodafone is one of Europe’s largest telecommunications companies. Whilst this year will be impacted by COVID-19, the company has confirmed an attractive dividend yield of over 6% paid from strong underlying cash generation.

BT surprised the market in May by completely cancelling dividend payments for 18 months, followed by halving future payouts to fund a massive fibre investment programme to connect 20m homes by the mid to late 2020’s. When we purchased BT we anticipated a significant dividend cut, although we did not expect a complete cancellation. We understand the rationale for the company’s Openreach division to ramp up investment into fibre connectivity. In fact, BT shares did not react that significantly to the dividend hiatus and ended the month unchanged. We continue to hold a reasonable position in BT, but due to our requirement for income we switched part of the holding into Vodafone.

We added another new company to the portfolio, Diversified Gas and Oil (DGOC). We have followed the business for some time and took advantage of its move up to a premium listing in the main stock market index from AIM to make an investment. DGOC owns a large portfolio of gas producing wells, pipelines and associated assets in North America. These are generally mature, but undermanaged assets that have been sold by companies, which are typically focused on drilling new wells for oil. The gas wells generate significant cash flows, much of which is hedged against commodity price volatility for several years into the future. The clear focus that DGOC management brings to these assets improves efficiency and prolongs well lives. The strong cash generation allows the company to pay a dividend yield of over 10%. Our investment coincided with a fund raising by the company to fund two acquisitions which further expand its scale and provide significant synergy potential.

The UK stock market staged quite a strong recovery from its low point in March, to the end of May, but remained down by over 15% since the beginning of our financial year. We find it hard to call the direction of the equity market in the short term, given the wild swings in investor sentiment we are witnessing in response to news on the pandemic. However, the stock market remains highly polarised. There are many companies that appear fully valued, or expensive, and we do not hold these in the portfolio. But we can still find many other businesses across a variety of sectors that are fundamentally sound, have strong market positions and are trading on attractive valuations. Some of these are economically sensitive businesses where profits are under pressure in the short term and a recovery in earnings will take time to come through, whereas others are more economically defensive and continue to generate robust cash flows and pay significant dividends.

We believe that a portfolio of these companies should deliver attractive returns to investors in line with Merchants’ objectives. Whilst dividend income is undoubtedly under pressure in the short term, we would expect most of the companies in the portfolio that have cancelled dividends to resume payments within the next two years, even if some will resume at a lower rate. Also, Merchants has significant revenue reserves, which the board has used previously to smooth dividend payments to shareholders at times when income has been under pressure.