Talking income

As the trust gears up for the release of its latest interim results, many investors will have an eye on the upcoming dividend. As an AIC Dividend Hero, the trust is well known for maintaining a steady dividend payment throughout the many ups and downs in market conditions over the past several decades. Host Jon Cronin and Portfolio Manager Simon Gergel discuss the approach taken to try to achieve the trust’s aims for shareholders and where the best opportunities currently lie for value investors in the UK market. A ranking, a rating or an award provides no indicator of future performance and is not constant over time. Past performance does not predict future returns.

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, welcome back to the show.  

SG: Hi, Jon, good to see you. 

JC: Well, it's very good to see you as well. And I want to think about events as they'll play out over the next few weeks because the trust is gearing up for its latest interim results, and many investors will, not surprisingly, have an eye to the upcoming dividend. Of course, the trust is well known for growing the dividend payment throughout the recent ups and downs in market conditions. So, Simon, talk me through the approach that you take here. And how you achieve these objectives. It's 41 years now of uninterrupted growth, I think, isn't it?

SG: Yes, that's right, it's 41 years and probably worth starting by saying that the dividend decisions are taken by the board of directors and the board of directors are independent of the managers – that’s us – so they set the strategy; they set the dividend policy. But clearly, we manage the business and the trust in order to deliver a high yield. Worth saying the other thing about investment trusts, of course, is that they are able to put money away in good years to keep growing the dividend in tough years. So that's really how we've been able, over 41 years of ups and downs in markets, ups and downs in dividends, to be able to continue to grow in the dividend; by putting money away in good times like before the financial crisis, or before COVID and then growing the dividend and using those reserves in more difficult times. Coming out of COVID, we've seen a strong recovery in the underlying income generating in the company - in the trust, we've continued to grow the dividend steadily. And actually, in the last dividends - so the first quarter of this year - the directors grew the dividend by 3.6%, which is a step up from the level of growth they've been able to do through the pandemic, which was obviously a bit more muted, when income had been under pressure.

JC: So, for you then, is this as much about stewardship – maintaining that growth – and I suppose taking the responsibility for delivering it as well? Do you feel that when you're making the decisions that you do?

SG: Well, we're very careful to only buy companies where we think we can make a good total return; so, companies where we think we can make money ultimately. But we fish in the pond of high-yielding companies. So, by having those high-yielding companies in the portfolio, overall, we generate enough income to allow the directors to pay that growing yield. But we're very careful not to get too distracted by the income or the yield on any individual company. You don't want to buy a company just for the yield, you want to buy a company because you think you can make money out of it. But by buying high-yielding companies, hopefully that delivers enough income. And we've been successful at doing that through very different periods over the last, you know, 40/41 years. 

JC: So, it's keeping your eye on the big picture. And of course, the source of income can shift depending on the performance of the different companies, the different sectors. So which sectors are generally performing well, at the moment, Simon?

SG: Yes. And when we're talking about performance for income, it's different in terms of share price performance – it’s not necessarily the same thing. They sometimes track each other, they sometimes don't. Where we see an income – the strongest income growth, not surprisingly perhaps, has come from the areas that were the most impacted during the pandemic. So, sectors like oil and gas – which cut their dividends heavily, and now seeing really strong cash flows coming through; they've been raising their dividend payments quite substantially. They're still below where they were before pandemic, but the growth’s coming through. Areas like banking have also seen a big growth in income and banks are now making good money and generating high-income streams and growing that. Some of the other cyclical areas have seen a recovery. Where I think the weakest areas are, are areas that are more vulnerable to a weaker consumer environment. So, I think some of the house building and housing-related areas – although we see good value there – I think we'd be most cautious about the dividend growth we might see in the short term. We may see some dividend cuts in that area. But overall, we're seeing a very good picture on dividend and income.

JC: And on that latter point - this is a long game, isn't it? You still see the value opportunity there. Even if perhaps, in the short term, the income isn't immediately tracking that.

SG: Yes, I mean, very often in markets you find the best opportunities to make money is when the uncertainty is greatest. And clearly, at the moment, the housebuilding industry is one of the industries under the most pressure because mortgage rates have gone up, housing transactions have gone down, and share prices have been very weak, and therefore there's a chance, and there's opportunities there, that could potentially make good money for shareholders. So, there is that conflict inherently as a value investor, between the short-term outlook for income – which can be challenging at the very time when the long-term opportunity to make money is the best. But by having a diversified portfolio, we've got enough income coming through even from the more resilient areas to keep the income story going, whilst potentially we can make good money from the recovery in share prices if we get our timing right, on those more cyclical areas.

JC: Okay, let's turn to the wider economy now, Simon, and it's increasingly looking as if we've seen the worst of the inflation spike – at least for now – whisper it, I may regret those words. But what does that mean for the value investor, such as yourself?

SG: Yeah, well, it's really important for companies. Firstly, the cost – inflation is a cost – and consumers clearly know it with a higher cost of food; higher cost of energy is squeezing their budgets and putting them under pressure and means they might spend less – or buy less quantity of goods. And it's the same with companies – higher inflation squeezes their ability to spend money and makes them more cautious. It also makes the Bank of England want to keep interest rates higher. So, if inflation is coming down, the squeeze on consumers – the squeeze on company budgets – is easing. And potentially the cost of interest might be coming down. And that has a magnified effect on the stock market, because it's not just the actual cost of money that affects companies, but investors – the value of a business, the value of a company to a shareholder - is effectively the present value of all the future cash flows that company is going to generate. So as interest rates come down, and interest rates tend to track inflation, the future value of that business goes up and potentially quite quickly, as interest rates come down. So, any sign that inflation – it’s a long answer, I'm afraid – but anytime that inflation has peaked, and interest rates might come down, is positive for valuations for companies, because it can lead to a lower discount rate and a higher valuation.

JC: It's a good answer, though. And it's an important point. And just on that point around inflation, and how interest rates track the movement of inflation. Of course, we're not expecting – in the short term at least – any reduction in interest, possibly quite the opposite. It'll still be quite tight, quite tough for some time, when it comes to rates. Would that be a fair assessment?

SG: Yes, I mean, we're not heading back anytime soon to half percent interest rates, which were a record low. I think interest rates may start to drift down, but the Bank of England is going to be very careful to make sure they've got inflation under control, to the extent that they can control it. And therefore, I think these interest rates may well be peaking. But I think the reduction of interest rates is likely to be fairly slow and modest, and more back-end loaded than some people might think. But the directional change is really important for sentiment in the stock market.

JC: And this is a question of sentiment, isn't it? This is, that even if it's a slower movement in rates, it's that sense that perhaps the worst is over and we can start planning, thinking about what we want to do in the future.

SG: Absolutely. The stock markets are driven by sentiment and the idea that we might be past the peak or past the worst is really helpful. And particularly for the more economically sensitive, the more cyclical areas of the stock market, which in some cases have been the most badly affected by nervousness, by investor concern. Those areas stand to benefit the most from a change in sentiment. 

JC: Just a few final thoughts on where you see the current best opportunities for the value investor, now then, Simon in light of all of this? You've talked on some of the businesses – the cyclicals – that are providing income opportunities. But more broadly, where do you see the wider opportunities for the value investor?

SG: Well, if we start with where the market is, overall, it's interesting at the moment; the UK stock market is close to a 20-year low in terms of valuation. Actually, at the same time, the US stock market is close to a 20-year high. So that's a really unusual combination. 

JC: That's remarkable. Is that something that has precedent? Has it been like that before?

SG: I don't remember seeing it - it's very unusual to see that level of dispersion and difference between the UK and international, but the UK has been gradually getting cheaper – or more lowly rated – since the Brexit referendum in 2016 it’s been gradually derating and investors have been taking money out of the market. But it's now pretty extreme. And the other thing that's notable about the market is within the market dispersion – the gap between highly rated and lowly rated stocks – is again very near the highest level has been in 40 or 50 years. So, you've got this lowly rated market overall, high dispersion – which means there's lots of opportunities to buy really good companies, sound businesses at incredibly, or very attractive levels, very unusual levels. So, we're finding lots of opportunities. And it's really across many different sectors. If I had to highlight a few, I think the whole building construction area has many businesses that are strong – fundamentally strong businesses – where because the short-term outlook’s difficult, investors have been really nervous and you've seen valuations go to very modest levels. But there's also opportunities in media; there's opportunities in the banking sector, in the energy sector, pharmaceutical sector. We're seeing this dispersion – these opportunities – across many different sectors. And so, the portfolio is quite broadly spread, actually, between consumer, industrial, defensive, cyclical, domestic, international earners. There's lots of opportunities in the UK.

JC: And just that differential between the UK and the US market - do you see that closing at any point soon? Do you see, perhaps, less of a gap as perhaps prices come in in the UK?

SG: I think ultimately, it should close and there's a number of mechanisms that can happen. Firstly, companies can relist – I mean, we've seen CRH, big building materials company, move their listing to America where most of their activities are, and that's helped push their share price up. You can see takeovers - you can see foreign companies coming in for lowly-rated UK companies – and we're seeing one or two of those coming through. I think they were a bit on hold when interest rates were high and volatile, but I think we'll see more takeovers. And I think confidence in the UK economy – the UK stock market – might gradually recover now that we've got a bit more political stability than we've had in the last few years. And actually, the UK economy hasn't been as bad through the COVID pandemic period as some people thought it would be and the economic statistics have been revised upward. So, there are reasons why the UK stock market could actually start to perform quite well and start to close that gap. But it's always impossible, or very hard in markets, to know when those things might happen.

JC: Well, one thing’s for certain – we'll continue to monitor and discuss those movements when it comes to the UK market and the companies listed on the UK markets. But we are out of time now, ourselves, for this particular edition of A Value View. But Simon – thank you very much indeed. 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 at the Merchants Trust, it's goodbye.