Valuation Over Sentiment: Merchants Trust’s Investment Discipline in Action

In this episode, Simon Gergel, Portfolio Manager at The Merchants Trust, discusses the trust’s unusually active first half of the year, with eight new stocks added to the portfolio. He explains the rationale behind recent disposals and acquisitions, and shares insights into how the team identifies undervalued opportunities in a volatile UK market.

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JC: Hello and welcome to A Value View from the Merchants Trust. Now, on this podcast we have a simple objective. And for regular listeners, you'll know this well. We aim to bring you insight and views on some of the biggest current investment issues of the day. And we do this as we always have done, by looking at the world through the prism of the Merchants Trust, which boasts a diversified portfolio of well-established and well-known UK listed companies. To guide us on this journey, I'm delighted to be joined in the studio by Simon Gergel, Portfolio Manager at the Merchants Trust.

Simon, it's good to be with you again.

SG: Hi, Jon. Great to see you again.

JC: Well, we've got a lot to talk about. And as we've already indicated, the Merchants Trust is made up of a broad portfolio of UK listed stocks. That diversity is one of the strengths that lies at the heart of the trust, along with astute and experienced stewardship, of course. But so is the ability for the trust to develop new ideas, to respond to and anticipate changing market conditions and to bring new stocks into the portfolio. So, Simon, let's talk about this. It's been a very active six months for new stocks. Talk us through this.

SG: Yeah it's been really interesting. So the stock market has been pretty volatile in the last six months. Not at the aggregate market level, although it has had some movement as well, but within that the individual trends have been pretty strong with one stock against another. So there have been a lot of opportunities to move the portfolio around. And just to give you some context, we have about 50 stocks in the portfolio and a typical year we might sell and buy seven, eight, nine, ten new stocks. In the first half of this year, which ended in July. We actually bought eight new companies, which out of a portfolio of 50 stocks is quite a lot. And that's really a sign that there's been some really significant moves in existing holdings, which have become more fully valued. And we've moved out of them and some new ideas coming through.

JC: Right. But what's interesting there is, as you say, what you would normally acquire over the course of, say, 12 months, you've done in effectively the first half of the year. So a lot of volatility, a lot of changes there. And what's driving that?

SG: Well we are driven very much by the individual opportunities we see. So on the one hand some of the companies we've owned for many years, some of the good quality companies, good quality retailers like Tesco, like Next, have performed very well and we've moved on. We've brought them closer to fair value. So they remain really good companies. But we've decided that they no longer really fit our… we can get better returns elsewhere. And on the other hand, we found out just a whole range of opportunities of new companies that we've been looking at that actually now meet our return criteria, either because the share price has come down to a level where we think we can get a really good return in the medium term, or else, because something has changed in the fundamentals of the business or the environment, which makes it a more attractive time to buy that company, or simply because we've had new ideas that have come from other colleagues that that we didn't/weren't aware of before.

JC: And what percentage of the trust would you say now is new, those new stocks that you're referring to? I mean, a sizeable chunk.

SG: Yes, I haven't actually added that up, but it must be 20% or something like that. So maybe, maybe a bit less so, but a decent chunk, given that we're only talking about six months of new ideas.

JC: Yeah. And as you say, I mean, those companies that are not in that list of new businesses, it's not that they're necessarily poor companies, is it? It's just that the opportunity perhaps is different.

SG: Yes. I mean, we we are very careful to separate what we might call a good business from what we might call a good investment opportunity. There are many good quality companies in the market, and we think we own a number of them. But a company doesn't necessarily stop being a good company when we sell it. We may well sell a company because we just don't, we think it's fully valued. And our job is not to spot great companies. I mean, many people can do that, is to find good companies when they are undervalued. And that gives us the ability to make both a good dividend yield, both a good income stream from those companies, but also to make a good total return. and so, yeah, there's plenty of good companies out there that we don't own, and we think we own a good collection as well within the portfolio.

JC: Okay, well let's have a look at some of those then. Those, those good companies that are undervalued. Who's who's in the new hit list.

SG: Yeah that's a good way of thinking about it. So, let's let's take a couple of very different examples. So one is a company Reckitt – used to be called Reckitt Benckiser, which is a consumer goods company, owns well-known brands like, you know, Finish and Vanish and Durex. And it's got some very strong market positions, globally. It's got a decent growth profile, but it's been under a cloud because of, particularly because of litigation in America on one of its products. And we thought that was a great opportunity to buy a really good company at a sensible price. And it's being reinvigorated as well under a, under a relatively new management team. Another completely different business company called Serco, which, is an outsourcing company for the government. It runs prisons. It does a lot of activities in the defence area. And we felt that that was becoming more and more of a defence company at a time when defence spending is ramping up, as we know, globally, and the market hasn't really worked out quite how much exposure it was having going forward to the defence.

SG: And it's made some acquisitions in that area, and the margins it can make in those areas are also, should be higher, because some of that's in America, where they make typically higher margins. So we just thought the profile of the business was improving and the valuation was at a pretty low level compared to other defence companies we could buy in the market.

JC: And on Serco, that's interesting because it's a result then you're saying because of the the huge increases in defence spending that we've already heard, announced and are expecting to see going forward in this country, across Europe and elsewhere as well. Businesses that are exposed to those defence industry companies, they themselves will stand in better stead as a result. Is that part of the thinking behind it?

SG: That's right. The spending in that area is likely to grow quite considerably over time. And if you can get exposure to that at a sensible price, it always comes back to price. If you get exposure to that theme at a sensible price, that's really interesting at a time when other defence peers are on our, you know, we're on significantly higher valuations. And then a third example just completely different is one that's come up from some of our European colleagues. We work very closely with other colleagues in other teams. In fact, one of the deputy managers, Andrew Koch also runs a European dividend fund. So one of the ideas that stocks we brought is Michelin, which is the tyre company. Most of what it sells, most tyres are sold as replacement tyres rather than for new vehicles. And so it's a much more reliable, dependable business than you might think, but it's also structurally moving into more speciality tires for high performance cars. Larger tires. Electric vehicles are heavier, they tend to have bigger tires and. Off road vehicles also are higher margin higher, higher specification. So it's got some nice structural trends in the business as well as being quite a sensible company. And it was trading on a modest valuation.

JC: Right. So our hunger for SUVs and heavy EVs electric vehicles, that's what's fuelling the potential for growth there at Michelin.

SG: Absolutely. And it has been over, over a very long period of time. Yeah.

JC: Okay. So you talked about, some of those conversations that you're having with colleagues as well. I mean, interesting just to touch on that a little bit. Where where do the new ideas that you're focusing on for these stocks, where do those ideas come from?

SG: Yeah, it's a great question and one we don't discuss that often, but we work as part of Allianz Global Investors. There's a large investment team, a large number of people looking at ideas. Some of those have a lot of experience looking at UK equities over the years, both large and medium sized companies. So we get ideas from other colleagues. and my team have got a lot of experience ourselves. I mean, I've been investing in the UK stock market for over 35 years. So one of the companies we bought this year, RS Group, which used to be called Electrocomponents, is one of the first companies I ever looked at in the late 80s, early 90s, so I've known it on and off for a very long period of time. So some of the ideas come within the team. Other ideas come from, because we own a few European companies, they own from come from colleagues running pan-European, money. So it's really a range of different areas that, ideas come from. And often it's companies we've owned before that come back into the portfolio. So Sirius Real Estate, which we bought, which is an industrial real estate company in mostly in Germany, but also now in the UK. We've owned that before. We sold it about five years ago. We actually were able to buy it back at a cheaper price than we sold it five years ago, which is a good demonstration, and the companies actually got better and progressed a lot. It's grown a lot since then. That's a good example of where we can, you know, go back to ideas and companies we've owned before.

JC: Okay. Of course, along with new stocks, there are also those that for various different reasons you need to dispose of as well to keep the portfolio at the sort of level and numbers that you would want to. So who are the ones that aren't in the hit parade that are moving out, at least for the time being?

SG: Yeah, well, we sell companies for three potential reasons. Firstly, and in most cases, the answer hopefully, is that the valuation has moved up and we've made the money we think we can make. It's trading closer to fair value. And therefore, you know, there's no reason to own it from an investment point of view. But they remain good companies and you know, companies like Tesco, which I mentioned earlier, like Imperial.

JC: Like you say, it's not a bad company, is it? It's doing very well, but it's just done what it needs to do for now.

SG: Haleon, Imperial Brands, you know, decent businesses. But, you know, valuations that we thought we were, less attractive than they were. And that ties in with one of the second reasons, which is if we find better opportunities elsewhere and really there's always a tension in the portfolio, or you like there to be a tension of new ideas knocking on the door saying, let me in. And you're saying is, are you better than something we already own? And in a sector like housebuilders, there's a lot of different opportunities. So you might well switch because you see a better opportunity. And then the third reason which is happens is where we've changed our view, either because something's gone wrong, which, you know, we we have a lot of portfolio stocks in the portfolio. We will make some mistakes. Or sometimes because the situation has changed, environments change. And we don't feel as confident as we did. So, you know, a company that we've sold, fairly recently, WPP, marketing services company, it has been disappointing. There's no two ways about it. It's been restructuring for many years, and we think that restructuring process may well be going on for a quite a long period in the future. They got a new chief executive. There are 1 or 2 question marks we've got about the structural position. And so we've decided to to move on and invest elsewhere where we've got higher conviction.

JC: So you have to make those tough decisions. Based on what you see.

SG: You do. You have to be objective. You have to always come in every day and say, do I, if I had a new portfolio today, if I had new money today, would I buy the stock today? And that's a good discipline to apply. It's quite difficult in practice, but it's always a good place to start.

JC: And how rigorous is the debate within the team? Obviously, you're the portfolio manager. You're sort of calling the shots. But, you know, you've described this broader team at Allianz. And those that you are immediately working with. Is there a lot of debate before you make a decision like say for instance, WPP?

SG: Absolutely. So there's three of us that work directly on the portfolio, myself and Richard and Andrew, and we will discuss everything very in great detail, but we also work with colleagues. We have a we have a UK equity meeting once a week, and we have a European value and dividend income meeting, if you like. And those two groups of people are slightly different but we will challenge ideas in those groups as well. And, you know, many of those people were discussing/ have been discussing WPP for quite a long time. So this is absolutely a live discussion. I find that in the small group, the three of us, we would tend to agree on most things, but there'll be a few stocks we disagree on. As the group gets broader and people have different approaches, we might have some growth investors in the team, in the broader team, we might get very different perspectives, but that's really valuable as well.

JC: Yeah, yeah. And is there a is there a cap on the number of stocks that you would hold in the trust?

SG: We say we own between 40 to 60. Ultimately, the board could change that if we wanted them to but we think that's a good measure. And the reason for that is you want to have a sufficient number that no one company or no two companies could really blow up your performance record. You need to diversify it. And, you know, we are going to make some mistakes. But equally you want every company to be meaningful. And so we don't like to have a whole tail of small positions. We like to have reasonably significant positions in everything, and somewhere between 40 and 60 feels like, and based on a lot of experience as well, and and we've got risk colleagues as well advising us. It seems to be about the right level.

JC: Okay. So final thoughts on this then Simon, where does all this fit together? what's your wider outlook for markets based on those decisions that you've taken just recently, both in and out of the portfolio?

SG: Yeah, it's interesting to approach it from this perspective because we are generally bottom-up stop. Because we always start by finding great ideas that we want to own and then we think about how does that fit together in the portfolio and what are our macro views, and what we're finding at the moment, as indicated by eight new companies in the last six months. Is there are a lot of ideas, a lot of opportunities in the UK market. The UK market, although it's had a decent rally, is still pretty cheap on a global basis and more importantly than that is really polarised. So there are many extremely cheap companies in our view, within the market, which is creating a lot of opportunities. So if we can build a portfolio of those companies, we can generate a good income stream, good dividend stream, which hopefully we can grow, which is a key objective of the trust. But also we think we can generate a good total return. We then have to calibrate that against the outlook, the economic outlook and the political environment and say, okay, under different circumstances, what might happen to throw that off course. And the economic environment is definitely challenging and there are there are pressures out there. The government finances are under pressure. Interest rates are likely to come down. But, you know, we don't have complete visibility on that. Which might be helpful, but the economic environment is difficult, so we've got to be conscious of that. But I think interest rates coming down over time should also give a bit of support to some of the consumer areas and the housing areas, which we've got a big exposure. So we are very confident that the portfolio we've got over time can deliver a good return and a rising income stream. But the markets are volatile, so you can't predict what's going to happen in the next six months. And nor can anyone else. But historically, if you've bought a collection of businesses, good companies at a low valuation, modest valuation, shall we say. That's usually delivered pretty good returns over the long term.

JC: Well, what's certain is that there's plenty to talk about, and there will be plenty more to talk about in the future on many of those issues that you've raised and I look forward to discussing them with you in future editions of the podcast. Unfortunately, now, though, Simon, we're out of time. Thank you for your time.

SG: Thank you Jon.

JC: And thank you for listening to a value view from the Merchants Trust. You can find out more about The Merchants Trust and read and watch Simon's latest investor notes by going to merchantstrust.co.uk. Thanks again for listening. And until next time, from all of us here at The Merchants Trust, it's goodbye.