Investing in Undervalued UK companies

The Merchants Trust was incorporated in February 1889, making it the oldest of the investment trusts in the Allianz Global Investors stable. Merchants have for many years focused on a simple proposition: investing for total return. That means delivering a high and rising income, together with capital growth, for its shareholders. Simon Gergel has managed the trust for over 20 years, investing in a diversified portfolio of large, well-established and well-known UK companies. Although past performance is no guide to the future, Merchants has paid increasingly higher dividends to its shareholders year on year for the last 44 years.

Simon and the team adopt an investment strategy known as value investing. That involves a focus on identifying undervalued UK stocks which have strong fundamentals (including factors such as a company’s profitability, revenue, liabilities and growth potential) but are underpriced by the market for various reasons and considered to be trading below their intrinsic value.

This investment style can often mean that the team’s thinking is contrarian, going against the broad market consensus adopted by other investment strategies and instead looking for undervalued investment opportunities. The strategy rests on three pillars:

• a fundamental focus on a company’s industry structure, financial metrics, and competitive position. ESG (Environmental, Social and Governance) factors are also considered in terms of their risk to the business in question. This would involve looking at, for example, whether the company is managed in a transparent and effective manner, if it treats its workers fairly and if it behaves in an environmentally-responsible manner.
• valuation (in absolute and relative terms, along with dividend yield); and
• structural themes (industry and secular issues, e.g., fundamental changes in, for example, technology or consumer behaviour that will change the way a sector or an economy operates. The growth of online shopping, for example, has clearly had a transformative impact on retailing.)

Simon and the team identify worthy value-driven investments, concentrating on owning good companies while not overpaying for them.

They seek to avoid value traps, where stocks appear undervalued but are facing significant structural challenges and are thus an unwise investment.

The team is equally rigorous when it comes to selling stock, if they can no longer make a positive investment case for owning a stock, they will sell it and use the proceeds to invest in better opportunities elsewhere. This has become increasingly important as the volume of undervalued opportunities has continued to increase in the UK market. The team also sell companies that have been doing well when they reach what the team believes is fair value.

While focusing on the UK, the Trust is able to invest 10% of its portfolio overseas, seizing opportunities when and where they arise. This flexibility allows the team to gain greater diversification of income generation and allows access to sectors which are not well represented in the UK market. It’s also important to remember that many of the UK’s leading value investments have business activities worldwide and therefore offer investors truly global reach anyway together with the UK’s high standards of corporate governance.

The Trust’s investment in Inchcape, the world’s largest independent car distribution company, illustrates how the strategy works. The business has exclusive relationships representing over 50 brands in more than 40 countries. Some of these relationships date back decades. Inchcape is consolidating a fragmented sector, as car manufacturers need strong partners in the smaller markets in order to provide the latest digital capabilities to consumers and to manage an increasingly complex industry structure.

The Trust’s investment in Hikma Pharmaceuticals is an example of how the strategy has opportunities with exposure beyond the UK. Hikma is a global manufacturer and supplier of a broad range of generic, specialty and branded pharmaceutical products. The businesses end markets span across North America, MENA and Europe with manufacturing capacity also distributed in these geographies. Hikma’s scale and expertise allows it to earn strong margins compared to its peers. Despite this, its valuation traded materially below its peers allowing a suitable entry point into the business. 

Investment risk management is, of course, a critical concern. Simon and the team think very carefully about the risks of individual companies and the risk at portfolio level. That involves a consideration of three main types of risk: operational risk, where the focus is on what could go wrong in the business; financial risk, which involves analysing the amount of debt and leverage facing a company; and valuation risk, where overpaying for a stock can prove costly.

In addition, Simon and the team constantly monitor the portfolio’s exposure to cyclical companies, whose fortunes are closely linked to the economic cycle and defensive businesses, which generate steady revenues almost irrespective of the state of the economy, international or domestic, and individual sectors. So, as well as assessing risk at the individual stock level, the team is alert to risks at the portfolio level , that should ensure the portfolio isn’t overexposed to any particular stock, sector or geographic market.

The Merchants Trust’s plc track record of consistent, growing income, with attractive long-term total returns, illustrates its success to date. It has even been recognised as an Association of Investment Companies (AIC) ‘Dividend Hero’, making Merchants a potentially attractive choice for income investors. Please note, however, that a ranking, a rating or an award provides no indicator of future performance and is not constant over time.