June marked 5 years from the Brexit referendum in the UK, a period which included considerable political uncertainty and the economic and human cost of the coronavirus pandemic. For most of this period inflationary pressures have been modest and interest rates and bond yields have generally been on a downward trajectory. However, we have recently seen inflation pick up and in June the Consumer Price Index moved above the Bank of England’s 2% target for the first time since 2018. In the USA, the Federal Reserve brought forward the expectation of its first interest rate rise to 2023 from 2024. Paradoxically, bond yields fell over the month as bond prices moved upwards. The equity market moved broadly sideways over the month with limited volatility.

Within the stock market the best performing large sectors were generally the more defensive industries such as pharmaceuticals, non-life insurance and tobacco, with oil & gas also performing well. The weakest sectors were cyclical industries or those that are sensitive to falling interest rates, including banks, life insurance and housebuilders. Portfolio performance was a little behind the market with recent strong performers giving up some of their gains, including Redrow, Legal & General and Tyman, whilst not owning AstraZeneca also held back returns. On the other hand, relative performance was helped by rising share prices at SThree, on a positive trading update, and St James’s Place. There was also a benefit from not owning HSBC which underperformed and held back the market return. The trust recorded a slight negative NAV total return of -1.3% over June, compared to a 0.2% return from the benchmark index.

We added two new companies to the portfolio in June, Tesco and Drax. Tesco, the UK’s largest food retailer also has a leading position in online food delivery and wholesaling to independent retailers and the catering industry. The business performed resiliently during the pandemic, with rapid growth in online sales in particular, and a sharper pricing policy against the discounters. However, catering supplies and bank profitability were impacted significantly. The company also took a costly but socially responsible decision to repay its UK rates costs which had been waived by the government. The company has been retrenching recently, disposing of its Asian and Polish businesses and returning cash to shareholders. Despite the resilient trading and the sharper business focus, the shares have lagged behind the market and were modestly valued in June. The investment case rests on a revaluation of the shares to reflect the strong underlying cash generation of the business, a recovery in Tesco bank, and the opportunity to gain significant market share in the fragmented catering and wholesale channels over the medium term.

Drax was historically the UK’s largest coal fired power station, but has transitioned into a 100% renewable power generator, operating biomass and hydro-electric generation assets, as well as producing wood pellets for biomass energy production. These pellets come from residues in sustainably managed forests in North America, where most of the timber production goes into the construction industry. The company is highly cash generative due to renewable energy subsidies it receives up until 2027, as well as valuable income from hydro-electric power, biomass production and other services for the electricity grid. Uncertainty on the outlook post-2027 has left the shares trading at a modest valuation.

The company is hoping to agree a subsidy regime with the government to allow bio-energy carbon capture and storage (BECCS) which could turn Drax into a major “carbon negative” generator, which could be critical in helping the UK become carbon neutral as a nation. This is a high-profile political project, and if commercially acceptable terms can be agreed, it could represent significant upside for the business and in turn may lead to a major re-rating of the shares. Downside in the shares is limited by ongoing profitability of their hydro generation assets, their pelleting operation and the other stability services they can provide to the electricity network, which provide enough cash to comfortably cover their 4% dividend yield.

Cash for these investments came mostly from shares that had performed well and offered less upside, including trimming holdings in Inchcape, St James’s Place and Entain, and selling the remaining position in Kin & Carta for a large profit.

Five years after the Brexit referendum, a long period of uncertainty, followed by the pandemic, has left UK stock market standing out as one of the cheapest of the major markets. This is despite the fact that the majority of profits of UK-listed companies comes from abroad. This can be seen among some of the “mega cap” multinationals in the portfolio, like Shell and GSK, as well as among smaller companies like SThree and Keller. With a high level of polarisation within the market too, there are still many opportunities to buy strong businesses on attractive valuations, paying reasonable dividend yields. We believe that a portfolio of such companies can continue to deliver income and capital returns in line with Merchants’ objectives.