Performance, Commentary & Portfolio

Fund Manager’s Review

February brought a broad range of economic data and geopolitical developments, as well as, a large number of corporate results announcements. This prompted some large swings in financial markets and divergent movements in share prices.

On the economic front, a few important surveys indicated a sharp drop in sentiment or confidence within the US economy. This could reflect a general uncertainty, over tariffs that President Trump may impose on imports into the US. A wide range of tariffs were threatened on regions like China, the European Union, Canada and Mexico, as well as on specific commodities, like aluminium. Dramatic cuts to the US public sector, under DOGE (The Department of Government Efficiency) and policies of deportation of illegal immigrants may also have impacted the economy’s ability to operate efficiently. A sharp fall in US 10-year government bond yields, from over 4.5% to around 4.2%, reflected a concern over the outlook for growth.

On the geopolitical scene, a succession of world leaders met with President Trump, who was attempting to secure a peace deal in Ukraine. He was seeking a deal that would allow the US to exploit mineral reserves in the country. It became clear that European countries, including the UK, will have to substantially increase their defence spending, to secure any lasting peace, due to the US refusing to commit to continuing military support. The Prime Minister, Sir Keir Starmer, promised to raise the UK’s defence spending to 2.5% of gross domestic product by 2027, largely by cutting back the foreign aid budget.

A deterioration in economic surveys and declining bond yields, coincided with a sharp sell-off in some the giant technology companies in the US, the so-called Magnificent Seven. The US stock market fell over the month. In the UK, the stock market gained just over 1% (total return), but there was significant polarisation. The large stocks in the FTSE 100 index were up nearly 2%, whilst medium and small sized companies were down around 3%. This is a significant and unusual gap, but followed a similar trend in January. The UK stock market seemed fragile, after significant outflows from investment funds. Any companies reporting disappointing trading, typically saw their shares fall significantly, almost irrespective of their valuation. Conversely, shares with momentum, and seeing rising earnings expectations, typically performed well.

The divergence in sector performance was notable. The aerospace & defence sector rallied 18%, both in anticipation of rising defence spending and in response to another positive trading update from Rolls Royce. The banks sector was also very strong, continuing a trend of the previous year. Banks shares were up 11% overall, with Lloyds up 17%, as the results season confirmed strong profits and cash generation in the industry. Lloyds raised its annual dividend by 15%. The pharmaceutical sector also posted good gains. On the other hand, a large number of sectors had negative returns, including personal goods, beverages, media and household goods & home construction, all down between 5% to 11%.

The portfolio return was significantly behind the market return, impacted by a large exposure to medium sized companies, which were generally weak. The Net Asset Value (NAV) total return was -0.69% compared to 1.32% from the benchmark, FTSE All-Share index. Three portfolio companies that lowered their earnings guidance, WPP, Tate & Lyle and Morgan Advanced Materials, fell between 17% and 22%. Not owning HSBC also affected relative performance, as the shares rose by 10%. On the positive side, Lloyds and Bank of Ireland both rallied by over 15% and not owning Diageo and Glencore was beneficial, as they both underperformed. In addition, the real estate company Assura gained 10% as the board turned down a bid approach from a private equity company. This looked like an opportunistic bid, taking advantage of a depressed share price to try to buy a collection of attractive assets on the cheap.

We added one new company to the portfolio, B&M European Value Retail. The company operates over 700 discount stores under the B&M facia in the UK and over 120 in France, as well as the chain of Heron discount convenience stores in the UK. B&M has a low-cost model of large stores, selling limited lines of stock that they buy cheaply in huge quantities. B&M sells household goods, homewares, toys and fast moving consumer goods. By selling mostly ambient products with long shelf-lives, B&M avoids the need for expensive refrigeration, enabling the company to offer better value to shoppers than the supermarkets. The company has a good long term record of growth, with strong financial returns and substantial cash generation. After a period of exceptional profitability during the Covid-19 pandemic, when the stores remained open as it was determined to be an essential retailer, profits have pulled back a little since. The share price has fallen significantly in the last year as B&M have cut pricing in certain areas and expanded the store base to reignite growth. This provided an opportunity to buy into a strong business at a highly attractive valuation, with a dividend yield of 5%, even excluding the numerous special dividends that the company has paid.

The B&M purchase was funded by selling down positions in several shares which had performed well and so offered less upside. In particular, we reduced the tobacco holdings after exceptional gains in 2024, as well as Tesco, AENA and Haleon.

The geopolitical and economic environment is highly uncertain, with the new administration in the US and the war in Ukraine. This is creating considerable volatility between sectors and stocks within the equity market, as described above. Stock market history shows that stocks on low valuations tend to outperform those on high valuations over the long term. With the current extreme polarisation within the market there is the potential for a major rotation at some point in the future. Many fundamentally sound businesses are trading well below our assessment of their underlying value. We believe the portfolio is well positioned to deliver an attractive income stream as well as superior capital returns, in line with the Merchants’ objective.

Simon Gergel
11 March 2025

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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