Performance, Commentary & Portfolio

Fund Manager’s Review

Politics came to the fore in May, with the prime minister Rishi Sunak calling a UK general election for July 4th, US Independence Day, whilst over in America, Donald Trump became the first former president to be convicted of a criminal offence. The UK election was called after the announcement of a return to economic growth in the first quarter of 2024, with GDP growing at a better than expected 0.6%, one of the strongest rates amongst major economies. Economic conditions continued to normalise, with CPI inflation dropping back to 2.3% in April, close to the Bank of England’s 2% target, from 3.2% in the prior month, although this figure was modestly higher than expected.

The UK stock market continued its recovery, hitting several record highs, with a rise of over 2%. There were some signs of a broadening of the market, as medium and smaller sized companies outperformed larger stocks. The stock market was helped by a number of takeover offers, as corporate predators sought to capitalise on the modest valuation of many UK stocks. There was a bid approach for one of Merchants’ portfolio companies, the power supply manufacturer XP Power, from industry peer Advanced Energy Industries. In this case, the board of XP Power rejected the proposal, which they described as opportunistic and fundamentally undervaluing the business, despite the considerable premium offered. This is the third bid approach seen in the portfolio in the first four months of this financial year.

Certain economically cyclical sectors led the market, including housebuilders, real estate and retailers, but there were also good gains in telecommunications and aerospace & defence. The worst performing sectors included utilities, which was impacted by the £7bn National Grid rights issue to fund electrification infrastructure, as well as beverages and oil & gas.

Merchants’ portfolio outperformed the benchmark, with quite a few companies delivering double digit percentage returns. The biggest three contributors to outperformance were all in the building industry.

The ground engineering company Keller continued its sharp rally, on the back of strong results, whilst housebuilder Redrow and materials producer Marshalls also rallied. Elsewhere XP Power rose nearly 40% on the takeover approach, and there was a benefit from not owning Diageo, which underperformed and held back the benchmark return. Merchants Net Asset Value (NAV) total return for May was 3.21% compared to 2.41% from the benchmark index.

There were few notable negative contributors, but Dowlais (see below) and the reinsurer SCOR were weak, and not owning Experian and Rolls Royce also held back relative performance as those shares rallied.

We added two new companies to the portfolio. Dowlais is a supplier of components and powdered metals for the automotive manufacturing industry, working with around 95% of global manufacturers. It was originally part of the industrial business GKN, but it has been restructured over the last few years by the corporate turnaround specialist Melrose, before being demerged and listed just over a year ago. Dowlais is world leader in sideshafts and propshafts that help provide power to the wheels of vehicles, as well as making many other products.

A key issue facing the company and the car industry is the transition from internal combustion engines (ICE) to electric vehicles (EV). Whilst most of Dowlais products are neutrally or even positively exposed to the move to EVs, a small proportion are dependent on ICEs, especially within powdered metals. These concerns have depressed the shares of Dowlais, and this has been exacerbated by selling pressure from former Melrose shareholders, who may not want to retain the stock. That provided us with an opportunity to buy shares at an exceptionally low valuation, which does not reflect the long term prospects for Dowlais, and the significant improvement we expect to see in both profits and cash generation, at the completion of the major restructuring in the business.

We also bought shares in Unite Group, the largest owner and operator of student accommodation in the UK. Unite and its joint venture partners own and rent out about 70,000 rooms, and have long term relationships with many of the UK’s leading universities. The business has grown over many years by building and acquiring properties and through rental increases. There is a shortage of accommodation in the UK, with many private landlords withdrawing from the market. We are also seeing growing student numbers. Together, these factors provide a structural tailwind for the company. Like many real estate companies, rising interest rates have impacted property values and brought the shares down to a level which does not reflect the company’s growth opportunities and its income generation. Both Unite and Dowlais also pay attractive dividend yields.

These purchases were funded by taking profits in several of the shares that had rallied, to pull back position sizes as they moved closer to fair value. Reductions included the retailers Tesco and Next, building companies Keller and Tyman, the energy company Energean and Barclays bank.

There seems to have been a subtle change of sentiment in the UK stock market over recent weeks. It feels like we are seeing more commentary about the number of takeover bids being launched for UK listed businesses, and we are seeing a few rights issues and even talk about new flotations (IPOs) which are signs of a heathier stock market. As we said a month ago, it is impossible to know whether this is likely to be a longer term trend. However, the UK continues to stand out in terms of its low rating, and a wide dispersion of valuations makes the London Stock Exchange a fertile opportunity set. We remain excited about the potential income and capital returns we believe the portfolio can generate over the medium term.

Simon Gergel
14 June 2024

This is no recommendation or solicitation to buy or sell any particular security. Any security mentioned above will not necessarily be comprised in the portfolio by the time this document is disclosed or at any other subsequent date.

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