A great opportunity set for investors

In this episode, Merchant’s portfolio manager, Simon Gergel is challenged around his ‘glass half full’ view of the UK market. Simon takes the challenge in hand explaining the factors behind his thinking and why, despite short term pain, the opportunity set for investors in the UK market remains pretty much unprecedented. We look at how Simon and his team choose good opportunities for the portfolio from that opportunity set, and which sectors are currently providing the best dividend opportunities.

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JC: Hello and welcome to A Value View from the Merchants Trust. In each podcast. Simon Gergel, fund manager at the Merchants Trust, offers his thoughts on developments affecting the UK market and what it means for investors. Simon, it's good to join you again for this, our first podcast of 2024.

SG: Hi, John. Good afternoon.

JC: Well, let's jump straight in because at the end of last year, we talked about some of the major challenges facing the outlook for UK markets, not least depressed sentiment following a run of poor economic data, and in addition, political and global uncertainty. However, despite the gloomy outlook, Simon, you took a more upbeat view. You told us there were reasons to see the proverbial glass as being half full when it comes to UK markets, so with a bit of distance and as 2024 picks up pace, is the glass still half full, Simon?

SG: Yes, well, we think it is. I think the reasons why the UK stock market has been out of favour really come down to politics, economic growth and inflation and the idea that somehow the UK has a far worse position on those factors. If you take politics, for example, we clearly had a period over the last six or seven years, we had the Brexit referendum, we had Jeremy Corbyn and Boris Johnson fighting it out, we had Liz Truss and Kwasi Kwarteng as prime minister and chancellor and we had a lot of uncertainty. I think what we've seen now with Rishi Sunak and Keir Starmer, on the other side as Labour leader who may well be the next prime minister, there's not a lot of gap in difference in their policies. So, politics looks relatively - from a financial markets point of view - looks relatively boring in the UK, at the time when half the world's electorate are having elections this year and far more polarisation if you look at the US or some of the European countries. So, we think, actually, the UK might go back to being seen as politically quite boring.

JC: Which is a good thing, isn’t it?

SG: It's a good thing for markets. Yeah, no, it's a good thing for markets. It may not be a good thing individually, you know, listeners may have their own views on what is or isn't a good thing politically, but from a market sentiment point of view it should be quite a good thing. And also, the one other thing we've learned from the period where Kwasi Kwarteng was chancellor, is that the markets will tell the politicians what they can get away with, what they can do on taxation and borrowing. So, they will be restrained, or constrained if you like, by the markets, So, that's the first thing that I think is positive compared to elsewhere. And then on economics, we had this idea that the UK economy was somehow the sick man of Europe, that our economy was growing weaker than everywhere else. And that's not the case. We've seen those numbers revised up, and the UK economy has performed very much like the average of the large economies in the last six or seven years. And the third thing was inflation. We had more of an inflationary spike, but that's rolled over and the inflation trajectory in the UK looks very similar to elsewhere. So, on all of those factors, the UK now looks pretty average, if not in terms of politics, less risky. But the valuation in the UK is a significant discount to other markets, particularly in America and I think that's really interesting. The valuation at this level is appealing and within the market, we continue to find lots of opportunities to buy companies within that, because the dispersion of valuations is very high. So, you’ve got a cheaply priced market and a high dispersion of valuations, which is a great opportunity set for an investor, really.

JC: Well, let's get back to valuations shortly. But let me pick you up on your second point in this thesis because there are still negative economic headwinds out of there, aren't there. Not least the revised figures, very recently, which showed that the UK economy had fallen into recession, and we are in technical recession now. So, how can the glass be half full when the economy’s in recession?

SG: Yeah, and I think we are we’re technically in a recession because we had two quarters of negative growth. I think Q3 was minus 0.1% and may yet be revised. So Q4 was minus 0.3%. These are not big numbers, particularly when inflation is running at 5%. So, you're talking about 0.1 out of five. It's a pretty modest number, and it could easily be wrong. I think if you look at the underlying, anecdotally what's happening in the economy, I would say it’s stagnation. The economy is pretty flat. Some industries like house building are contracting. There are fewer houses being built today than there were previously. Other industries are growing modestly. So, we're not seeing what you might see in a deep recession. We're not seeing huge rounds of redundancies and layoffs and retrenchment by companies, and you know, that might come, that's always a risk. But at the moment we're seeing, I would say, stagnation in the economy, and it's not that bad. And, of course, it's important to remember as we've discussed many times before, that when you invest in the UK stock market, you're not just investing in the UK economy. About 70% of sales and profits of UK-listed companies come from abroad, so the direct impact of the UK economy on our stock market is somewhat limited.

JC: But what about that point on the equities that you're investing in, often being more closely connected to countries outside of the UK. If we're saying that the UK is more boring, more stable, whereas elsewhere, there is still polarisation and uncertainty, surely those same businesses are going to be affected by that, and their businesses that you're investing in here in London?

SG: Well, that's a great question. I think the reason we talk about that is because the sentiment for UK equity, the sentiment for the UK stock market, is very depressed because people think there's a political risk, even though there isn't. Where the people don't really focus necessarily on where the company's end markets exposure is so, for example, our energy companies trade at a significant discount to the US-listed energy companies, even though they're both global businesses. Or I should say they're all global businesses, and they have a very similar end-market exposure. So, what the reason for talking about sentiment being depressed for the UK and politics being seen as risky is about whether investors choose to buy UK-listed companies. Not where the end markets really are, Which, as you say, is very global in many cases. Does that make sense?

JC: Yeah, absolutely. So, let's get back to that point then on valuations, your third point as well. How do you spot an opportunity in this situation and how do you identify those companies that are undervalued at the moment, but you can catalyse on now for the benefit of investors in the future?

SG: Yeah. I mean, we always focus on three things, and I can give you an example, as I go through. The first is, it's not just about valuation. We're looking for fundamentally sound, strong businesses. I mean, we bought a company two or three months ago, called Assura Health which is an owner of mostly GP surgeries. The owner of property for the healthcare industry, largely GP surgeries. They've got about 10% of the market. So about 10%, 1 in 10 GP surgeries are owned by Assura. And it's a very solid business, they've got very strong assets. The tenant, although the tenant is GP’s, the rent is paid by the National Health Service, by the NHS. So, it's a very reliable dependent tenant, um, customer if you like, that can pay the rent.

JC: Certainly plenty of money there in one way, shape or form.

SG: Well, there's a lot of money there. And also there isn't that much surplus supply of space so the GP’s are desperate for space. They can’t move out of the Assura properties into alternative space because there simply aren't enough surgeries and there aren't enough other properties for them to move into. So, you've got strong business with decent rental coming in. Actually, some sort of inflation protection, which is helpful. So, that's the first thing we look for is a solid business and also a very cheap cost of debt with long-term borrowings that they've got, which is very favourable. Second thing we look at is valuation, and the company is now, because of the way markets have moved, the valuation’s come right down. The shares are trading at a discount to their asset value, which is always interesting and paying a high dividend yield. So that's quite attractive. And that was when we bought the shares, I should say. So, you've got a good company with attractive valuation, which are two of the three things we look for. And the third thing we look at is what's going to change. What are the long-term trends in the industry and what we know about this industry is this tremendous long-term demand growth for these types of surgeries, these types of facilities, that the business can therefore continue to develop and build new ones, which they've been doing in the past. So that's a long-term positive trend. There's an element of inflation linkage I touched on earlier, which is another positive trend. And the other thing is, the valuation of properties are linked to bond yields and bond yields have gone up a lot. But we think over the medium term they might come down a bit further, and as bond yields come down, you would expect the valuation to go up. So, there are some supportive trends. So that's how we identify companies. We look for strong businesses with good balance sheets, and you know, a sensible management team. We look for attractive valuation where we think you can buy the company below what we think it is really worth and you look for supportive, long-term themes that can help drive that change over time. Does that make sense?

JC: Yeah, absolutely. So, there's a strong example there of how you're seeking opportunities. But let's just wind back to our first thought in this podcast, and that is around the glass being half full and reasons to be perhaps more optimistic, more upbeat about where markets are heading. You see the opportunity for changes there. Perhaps there's interest rates come down and the bank stops suppressing so much of the UK economy in order to deal with inflation. But when are the changes that will be more favourable for investors? When do you see them coming through? Are we seeing things improving much more so, later this year? Sooner this year? Or much further down the track? When do you expect to see a shift?

SG: It's always easiest to see catalysts in the rearview mirror. It's very hard to know when this changes, but I think, anecdotally, we see lots of signs of interesting developments. I mean, take Barclays Bank who announced results this month, earlier in the middle of February. What they said is they're now generating strong profits and good cash flows, and they intend to return about £10 billion to investors over the next three years if things go well. Now, £10 billion might not sound a lot for Barclays Bank, but it's actually over 40% of the value of the company at that time. Which means as an investor in Barclays, they're going to be paying you back, either in terms of dividends or buying back their stock, about over 40% of the value of the company, if they deliver the profits they hope to in the next three years. And you're still going to own the company. You’ll still own the business you've got in three year’s time. It's not going to diminish. In fact, it should have grown over that period. That's an interesting sign of how low the valuation of some of these companies has got.

JC: Are you saying if Barclays are doing this, then perhaps things are turning around sooner than later?

SG: Well, you’re seeing many companies start to do it. And so the marginal buyer of the UK stock market, ironically, is the company themselves. Now, I mean, Barclays is going to be buying a huge amount, something like 8% of the market value every year they can buy If the share price doesn't move, and at some point that should start to drive the share price, and they're not the only ones. I mean many companies in our portfolio are now buying back their own stock, and in fact, the overall market is contracting, if you like. Companies are buying back more equity than is being listed, and once people stop selling the market, almost by definition, the price has to go up if there are buyers, and the companies are buying back stock. So I think that's really interesting. And there are very few domestic institutions who have large investments left in the UK. The average pension fund and insurance companies have gone from owning 50% of the market, 40 years ago, to owning about 4.5% today, according to the FCA, so a lot of the traditional owners of the companies have sold out now.

JC: It's fascinating. So, look. Let's finish on dividends because I think we're heading in that direction. Which sectors then in the portfolio - you've identified Barclays already - are currently offering the best dividend opportunities? And separately, what does this mean for the Trust's own dividend?

SG: Well, it's worth saying, we don't buy companies simply for the dividend yield. It's really important that we try and buy companies where we believe we can make good money and for the criteria I set out, for good businesses that are cheap with supportive themes, ideally. As it happens, we think the big banks do offer a combination of attractive dividends and a good potential total return. Companies like Barclays, I talked about. But we also see value in many other sectors, the whole building and construction area. We find a lot of companies, everything from house builders to companies making building products and distributing materials, we find good value there, and some of those have good dividend yields. The utility sector - we have some good yields. Reinsurance within the financial services area; reinsurance is another area we like and we see very strong trading results coming out of the reinsurance companies after several periods, several years of raising their prices to consumers. So, there's quite a lot of opportunities and it's quite widely spread actually in the market. It's not just in cyclicals or defences or domestic stocks or international stocks. It’s actually in most of the sectors, you see quite a big divergence of valuation and a lot of opportunities. How does that translate to Merchants? Well, I mean, I can't talk about the year that finished in January 2024 because we haven't reported, But, we were seeing earlier in that year, we were very strong income growth coming through in the portfolio at the interim stage. The directors raised the dividend and so we have grown the dividend every year for 41 years, and we hope to continue to do that. And as we look at the outlook in general, we’re see robust dividends reported by companies. I think the concern going into recession is, are we going to see a lot of dividend cuts in the market? We don't think we're going to see anything like the pandemic where you had wholesale dividend cuts across the market or even the financial crisis where you had a lot of different reductions.

JC: But that's because you think that the recession is really - even if it is a recession - very, very light?

SG: It feels much lighter. But also industries like banking, industries like energy, have reset their dividends and actually reset their balance sheets. So, the big banks are far more strongly capitalised now than they were back in the financial crisis, and the energy sector has a much lower payout ratio, a much stronger cash flow than it had the last time round, so a lot of the big dividend paying sectors of the market should be more resilient, even in an economic downturn, than they were last time around.

JC: Well, Simon, I'm afraid we'll have to wrap up there. I think it's safe to say that the glass still remains half full for you. Maybe we can just touch on that again one more time when we catch up again for the next podcast and see how events have played out. But for the time being, thank you very much, indeed.

SG: Thank you. 

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, until next time from all of us at the Merchants Trust, it's goodbye.