September saw a continuation of political uncertainty. There was no sign of an end to the rumbling US / Chinese trade tensions. In the UK, the Brexit situation remained fluid. The Conservative government prorogued parliament for several weeks, but this was ruled unlawful by the High Court, forcing a hasty return to Westminster. The questions of whether and how the UK would leave the EU by the end of October remained open with just a month to go, despite Parliament passing a bill to force the prime minister to seek a Brexit extension if no deal is agreed by mid-October.

Most major stock markets produced positive returns in the month with the FTSE All-Share Index up around 3%, but with significant volatility within the market. There was a sharp rotation from the perceived high quality, high growth stocks, which had been leading the market in prior months, into more lowly valued shares including higher yielding shares, which had lagged behind. Among the larger sectors in the UK life insurance, food retail, financial services, banks and real estate performed well, whilst personal goods, beverages, media and tobacco produced negative or – at best – flat returns.

The Merchants Trust’s NAV gained 6.2%, well ahead of the benchmark return of 3%, reflecting in particular the portfolio bias to more lowly valued companies and sectors that outperformed. The biggest positive impacts came from Hammerson, where the shares rallied by 25% from a depressed level, and Standard Life Aberdeen, Tyman and IG Group, which all gave double digit returns. IG in particular responded well to a positive trading update. On the flipside, the biggest negative impacts came from Imperial Brands and Keller, which both had slightly disappointing trading updates, whilst Senior shares were also weak.

We added one new company to the portfolio. DFS is the UK’s leading sofa retailer with over 30% of the sofa market under their brands; DFS, Dwell, Sofa Workshop and the recently acquired Sofology. The company is the clear market leader with a long history of market share gains and it has significant scale advantages in manufacturing, sourcing and distribution. The shares were lowly rated due to general concerns about consumer confidence and online disruption threats. However, sofa retailing is relatively well protected against pure online retailers, as the product is made to order so manufacturing efficiencies are critical, people like to touch and feel the product, and logistics is complex and costly. Whilst the end market is cyclical and economically sensitive, we see potential for a medium term improvement from here as consumer confidence is already weak and could benefit from any resolution to the Brexit situation. Furthermore, housing transactions are running at a low level and sofa purchases are often related to house moves. The company also stands to gain from cost savings from the Sofology integration and from renegotiating property leases.

Apart from this transaction, there was less activity in the portfolio than in recent months. We took some money out of TP ICAP, CRH, Meggitt and Informa, which had performed well, and added to WPP where there are some signs that the business restructuring is starting to lead to improved operational performance.

We have previously written about the extreme polarisation in the stock market between those stocks perceived to be better quality and offering high growth, which are generally very highly rated, and more cyclical stocks and financial companies which are often very cheap. Whilst Merchants has benefitted from a sharp rotation of the stock market from the former to the latter category in September, the gap between the two areas remains unusually large. We continue to see excellent value in many of the companies in the portfolio and we have only modestly changed its composition. We believe that the portfolio companies have potential to deliver both a high income stream and a good total return in line with Merchants’ objectives.