September seemed to bring an autumnal feel to the UK. Not so much the change in the weather, as surging energy prices, causing the collapse of several energy suppliers, and fuel shortages at petrol stations, caused by a shortage of lorry drivers, which exacerbated logistical problems and lengthening supply chains across many industries. These factors, on top of other inflationary pressures, threaten the pace of profits recovery and growth into 2022. However, this should be seen in the context of a domestic economy that has been growing fast, with second quarter economic growth revised upwards to 5.5% at the end of the month, record low interest rates, high consumer savings and increasing government spending on infrastructure.

The stock market also reflected a change in the seasons, with a small decline over the month, but a notable change in leadership. Energy was the stand-out performer, with both BP and Shell up by around 15%, on the back of firm energy prices. There were modest gains in travel & leisure, aerospace & defence and banks, but most sectors produced negative returns. Amongst the worst performing industries were construction, housebuilding, real estate and mining, which was impacted by a sharp fall in the price of iron ore.

The portfolio performance was modestly ahead of the broader market, reflected in a NAV total return for the month of -0.87% versus the -0.96% from the benchmark index. Biomass and hydro generator Drax benefitted from higher electricity prices, whilst positioning in the energy sector was also positive and SThree continued to perform well. On the other hand, not owning pharmaceutical company AstraZeneca and miner Glencore were detractors from relative performance as both shares performed well, with AstraZeneca buoyed by positive drug trial results. Elsewhere IG Group shares underperformed, despite solid first quarter results.

We made a new investment in Homeserve during the month. This company offers various heating, plumbing and electrical insurance and repair services to homeowners in the UK, US and certain European countries, as well as owning the online services directory Checkatrade in the UK and similar businesses overseas. It has a strong growth track record, over many years, with a particularly successful and market leading US business. The shares have fallen back in the last year on the back of disruption to Checkatrade’s growth from the pandemic, and some other specific issues, such as the decision to cancel and write-off a new IT system. This brought the valuation down to a level which, in our view, did not reflect the growth prospects or quality of the business. Elsewhere, we continued to build the position in Drax early in the month, and also added to household products company PZ Cussons after a reassuring trading update.

The largest sales were the two companies that received recommended takeover bids in August. We sold out of Meggitt completely and sold approximately half of the holding in Stock Spirits, both at prices above the agreed takeover bids. We also sold the remaining position in Inchcape after the shares had more than doubled from their 2020 low point, and the valuation had reached our assessment of fair value. In addition to the benefit from realising gains in these shares, the recycling of capital into new investments also helps the Merchants’ income generation. Despite Meggitt and Inchcape both suspending dividends during the pandemic, we held onto the shares, and indeed added to the positions, believing that they offered considerable upside potential. Selling these companies at fair prices, along with Stock Spirits, provides funds to invest in higher yielding shares.

As we touched on above, the outlook for company profitability is subject to contrasting forces. Order growth in many industries is robust or even strong, benefitting from pent up demand, high consumer savings and low interest rates. Yet cost pressures are building, and many companies are suffering from logistical challenges. We expect to see greater differentiation between company performance in the coming months, with operational resilience and the ability to pass on cost increases to customers becoming increasingly important. We have constructed a portfolio of reasonably priced, but sound quality businesses, that we believe can perform well in the medium term, in order to deliver an income stream and capital returns in line with Merchants’ objectives.