From Interest Rates to Breakfast Plates

What’s in store for UK interest rates and investors as we approach year-end? In this 32^nd episode of a Value View podcast, portfolio manager Simon Gergel shares his outlook and discusses the factors that had informed the investment case behind Whitbread, owner of Premier Inn. Listen in to find out if Premier Inn’s all-you-can-eat breakfast will stay on the menu.

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JC: Hello, and welcome to A Value View from the Merchant’s Trust. Thanks for joining us. Now, the objective of this podcast is a simple one. We aim to bring you insights and views on some of the biggest current investment issues of the day. We'll do this by looking at the world through the prism of the Merchant's Trust, which boasts a diversified portfolio of large and well-established and well-known UK-listed companies. So, who better to guide us on this journey than Simon Gergel, portfolio manager at the Merchant’s Trust. Simon, it's good to be with you again.

SG: Hi Jon, it’s good to see you.

JC: Well, it's great to see you, and I don't know about you, Simon, but as the autumn days start to draw in here in London, there's a real sense of minds beginning to focus on what the rest of this year might hold for investors. We have a new government, one that's clearly got its own plans for the UK economy. And with inflation seemingly under more control, we're seeing renewed speculation on the direction that UK interest rates might go in. The Bank of England recently held rates at 5.0%, but many expect to see that figure drop soon. So, Simon, what's your view? What should we expect to see in UK interest rate policy over the coming months?

SG: Yeah, well, I think the direction of interest rates is pretty clear now. We've seen the first cut in the UK and we would expect to see several more. We've seen the ECB, the European Central Bank, cut rates, and we've seen, of course, the US Federal Reserve cut by 0.5% on their first cut of the cycle. So, rates coming down, and the reason why rates are coming down is because inflation has returned back to roughly where the Bank of England's targeted around about 2%. Um, and therefore interest rates at 5% are probably too high, and are restraining activity in the economy. So they will come down, it's a question of how quickly and how far they go. Um, it's very hard to call exactly how that's going to go, the market expects rates to come down quite a bit further, um, but I think the direction is probably more important than where we actually end up.

JC: Do you think the Bank of England is being overly cautious then, if we've seen rate drops in the eurozone, the Fed Reserve doing the same. Could it be that the Monetary Policy Committee, the people who make that decision at the Bank of England are being too cautious? There was only one vote in favour of a cut at the recent meeting that they had.

SG: There's always a danger that central banks are going to be too slow to cut interest rates because they're, you know, they're more worried probably about getting it wrong by bringing rates down too early, if inflation remains a problem. Um, so that's always a risk. I mean, I think it's, it's a very tough call.

JC: But the bank was criticized for not raising rates fast enough. Could it be that they faced the same criticism for the situation we now currently in?

SG: It could do, absolutely.

JC: The era of ultra-low rates is clearly over though, Simon. One where potentially lower interest rates environment is something that we'll get more used to. What does that mean for the businesses that you're investing in?

SG: Well, lower interest rates are generally positive for the economy. As I say, higher interest rates, mean your mortgage costs are higher, companys’ borrowing costs are higher, so as interest rates come down, the cost of doing things - the cost of investing, and, you know, using money to buy things, comes down and therefore activity tends to pick up. Some businesses benefit more than others, those with a lot of leverage would benefit, a lot of debt. Real estate valuations might benefit because real estate valuations also work on a yield, which is a bit like an interest rate. How much are you getting a return on your assets, as interest rates come down, property yields tend to come down and that lifts property values. Banks, on the other hand, it might be a bit less beneficial. They've benefited from interest rates going up to some extent, but there's a happy medium for banks. But in general, lower interest rates - its good for the economy and particularly for the more cyclical businesses that… because consumer spending activity from companies tends to pick up as interest rates come down.

JC: I won't ask you to predict, absolutely, but I'll give you… I'll ask you for your best guess. Do you think we'll see at least one reduction in interest rates this side of Christmas?

SG: I think, I think that's likely, yeah.

JC: Now changing tack slightly, in your latest fact sheets you talked about a couple of new stock purchases. One of these was Whitbread, owner of the Premier Inn hotel chain. So, what was your investment case for the portfolio when you bought it?

SG: Well, Whitbread’s a long-established company in the UK and it used to own Costa Coffee and so on, and it's, it's built up the Premier Inn chain to become the UK's largest hotel company. And it's got some great assets. I mean, firstly, they own half their freeholds, which gives them much more flexibility with the estate than they might do if they were all leasehold properties. Secondly, because they've got such a large market share and such a strong brand in the UK, they're able to get almost all their bookings direct to their website, which saves them the cost of going to other people like Booking.com or other agents. And that makes it more efficient. And they've got a proposition that resonates well with the UK customer base at a price that's more affordable than some of the more expensive hotels. So, they've historically grown well and have been a strong business with a strong asset backing. They've built up, more recently, a large position in Germany. So, the German market is larger than the UK and very fragmented. They built about a 1% market share - a lot less than they've got in the UK, but it's still a good starting point. But the market leader in Germany's only got about 2%, so they're clearly trying to grow in Germany and trying to attempting to build a position along the lines of what they've done in the UK. And that's a big opportunity, but at the moment, Germany has been loss-making. So, it's been a drag on profitability. In terms of why the shares are interesting, what we've seen in the last 12 months, is we've seen a slight slowdown in activity. So, if you remember coming out of COVID, a lot of people took domestic holidays. So, the UK hotels were very busy in 2023 and they were able to charge very high, high prices. This year, I wouldn't say it's been weaker, but it's not grown that much this year. It's been slightly softer because it's more and more people have gone internationally for their holidays. There's still been decent bookings but that's just slowed expectations a little bit and the stock market doesn't like it when expectations for growth come down. So that has been one of the factors that weighed on the share price. I think the losses in Germany have weighed a little bit on the share price. And the third factor is they've decided to restructure some of their restaurants. and convert some of the space into additional hotel rooms. Now that is very positive on the long term because it should allow them to make higher room sales and higher return on capital. But in the short term, it’s also a drag on profits because they're going to make less money over the next 12 months than they would have expected to make previously because of the cost of that, or the disruption of that. You put all those factors together, you've had a bit of a downgrade in expectations for the market, and the shares have fallen very heavily, and those factors brought the share price down to a level at the time we bought it that we thought was really attractive.

JC: But you see the potential there for the German market, obviously a huge market and one that if they're at 1% and the market leaders at 2%, well, already clearly making inroads.

SG: Absolutely, and they're growing their rooms aggressively in that market. And then the third thing, which is a bit more short-term, is they've announced they're going to restructure some of their restaurants. Often, they own the harvester chain, which is often next to the hotel. And they're going to turn some of the restaurant rooms, sorry, some of the restaurant space into traditional rooms, which will allow them to earn a much more, much better return on capital. More profitability because the restaurants aren't particularly profitable for them. So that, but that has a short-term drag, and the drop in this year's expectations of profits has worried some of the analysts and that's probably led to some automatic selling for people who don't like when they see earnings forecasts coming down. Ironically, it's very good news long-term because it increases the long-term profitability, but because of a combination of those factors, I think that's brought the shares back significantly to a level that we thought was very attractive when we bought them.

JC: OK, now just on this point - that last point on converting restaurant space into hotel rooms. This is an important question. Premier Inn, will it continue to offer their all-you-can-eat breakfasts first thing in the morning? I know that my family certainly have frequented that numerous occasions, and it is a feature that many people associate with Premier Inn. Is that going to go?

SG: Yeah, it's a great question and very important. So they're not getting rid of restaurants. They are making sure that every hotel still offers a good breakfast and what they're doing is they're either converting some of the space in the hotel, if they're moving the restaurant completely, or they're retaining part of the restaurant for their breakfast for the guests. But what they're not necessarily doing is having so much space for external visitors and so on. So, they can restructure the estate. They've actually sold… they're actually selling some of their restaurants to other operators, but they'll still be available for customers to get a breakfast. So yeah, you can rest assured that you and your family will still be able to get a breakfast.

JC: That's good news. So, the full English is safe for now, at least. More generally, we're also starting to see a bit more interest In UK equities. Just talk us through that.

SG: Yeah, it's been interesting. I mean, we've been saying, as you know, for a long time that the market is cheap and that politics is becoming less risky in the UK, or a little more stable, shall we say, with…

JC: A bit more boring…

SG: A bit more boring…

JC: We’ve been hoping for that for a while, haven’t we.

SG: Which is good. Inflation's come down, the economy is starting to recover. Life is turning more to normality in the UK. The reasons for not owning the UK, compared to other markets, I think have fallen away, and the valuation's cheap. So, what you're seeing retail fund flows – so investors buying and selling investments in the UK, equities - they were sharply negative. They're moving much more closer to neutral. And actually, for the first time since the middle of 2021, there's a well-known fund manager survey by Bank of America, that's saying that the managers want to be overweight, have more in the UK than their benchmark. Really, for the first time in about 3 years. So that's really interesting. So, these are anecdotes, this is not yet a definite trend, but certainly the negativity we were seeing on UK equities is turning to something more neutral or possibly even positive. And I think that makes sense. We're also seeing a lot of takeovers of UK companies, which is stirring interest.

JC: OK, so reasons to be cheerful. We'll have to wrap up the podcast at that point, Simon, but thank you very much indeed for your time.

SG: Thank you, Jon.

JC: Thank you for listening to A Value View from the Merchant's Trust. You can find out more about the Merchant's Trust and read and watch Simon's latest investor notes by going to Merchant's Trust.co.uk. Thanks for listening, and until next time, from all of us here at the Merchant's Trust, it's goodbye.