News that the economy eked out 0.1% growth in February will bolster Mercantile (MRC ) fund managers in their conviction that the depressed UK stock market is poised for a rebound.

Following the 0.3% rise in January, it looks increasingly likely the UK has pulled out of the shallow recession at the end of last year and will record a positive first quarter.

For JP Morgan’s Guy Anderson and Anthony Lynch, whose £2bn mid-cap portfolio has been weighed down by fears over inflation and interest rates, the GDP figures underline why they have positioned themselves for an upturn.

With employment levels ‘resilient’ and after 10 consecutive months of real wage growth as inflation has fallen, the managers believe the foundations are set for greater consumer demand, more business investment and better corporate earnings growth.

Revealing in Mercantile’s annual report that they had lifted gearing, or borrowing, to a ten-year high of 15% from a one-year average of 12% to make the most of an upturn, they said: ‘Any improvement in such prospects could yield healthy market gains, as the prevailing negative sentiment and uncertainty over the outlook is evidently reflected in valuations, with the UK market trading at a steep discount to both its own history and relative to other developed markets.’

In early trading the shares rose 1.8% to 226.5p at a 13% discount to net asset value, but ahead of the 0.7% gain in the trust’s FTSE 250 benchmark index. 

The results showed Mercantile achieved a small but significant advance in the testing market conditions in the year to 31 January. With debt at fair value, the trust’s assets generated a 5.4% total return with the shares providing slightly more at 6.1% with dividends included compared to 1.8% from the FTSE 250.

The company said its shares had returned an average annual return of 6.4% in the past decade, again beating the benchmark’s 4.5%.

Dividends rose 7% with a fourth quarterly interim dividend of 3.3p taking the year’s total to 7.65p and putting the shares on a 3.4% yield. Payouts have lagged inflation in the past three years, rising 4.5% a year against the 6% annual increase in the cost of living. Over 10 years, however, the situation is reversed with Mercantile’s dividend growing by 6.7% a year against he 2.8% annual rise in the consumer prices index.

In response to the discount swinging out close to 17% last autumn, the board, chaired by Gordon Lennox, bought back just over 8m shares at a cost of £16.5m, bringing the gap to NAV back to the 12.7% level at which it had started the financial year.

Despite the uninspiring economic and market backdrop, most of Mercantile’s companies traded well with the managers’ stock picks responsible for most of the outperformance against the index, aided by the gearing.

As with many UK equity funds, Mercantile said 3i Group (III ), the private equity giant benefiting from the strong performance of European discount retailer Action, was its best performer, followed by alternative asset manager Intermediate Capital (ICP).

The managers did well to add to their positions in Bellway (BWY) and Redrow (RDW) as the house builders rallied from lows in the fourth quarter on the expectation of interest rate cuts this year. 

Watches runs out of time

However, the duo cut their losses and sold out of Watches of Switzerland (WOSG). The luxury watch retailer was their biggest faller after Rolex, its key supplier, threatened to enter the retail market, which was followed by a profits warning caused by a slump in Christmas trading.

‘While this is the first profit warning that the company has issued since its listing in 2019, it raises significant questions over the deliverability of their long-range growth targets, so we have exited the investment in full,’ the managers said.

By contrast, a decline in audience figures at specialist media platform Future (FUTR) hit its profits and shares price, but the managers held on waiting to see what difference a new chief executive makes. 

In addition to the WOSG sale, the managers exited Pets at Home (PETS) and Spirax-Sarco (SPX), the industrial machinery supplier after its promotion to the FTSE 100, and reduced a holding in electronics distributor RS Group (RS1). 

Money from these went into a big increase in Hill & Smith (HILS), the infrastructure engineer reaping the benefit of US government spending, topping up a position in technology re-seller Bytes (BYIT) and new investments in Bodycote (BOY), the industrial engineer enjoying the recovery in aerospace, and airline and package holiday provider Jet2 (JET2). 

Another new holding was taken in Moneysupermarket.com (MONY) which the managers believe had scope to ramp up profits on the back of higher insurance prices and the completion of a technology overhaul at its platform.

Lastly, in line with their views on the economy, the managers were less bearish on real estate and, while still underweight the sector, had bought into LondonMetric Property (LMP), Shaftesbury Capital (SHC) and Tritax Big Box (BBOX ).

Stifel analyst Iain Scouller said: ‘We think Mercantile is a good way to gain exposure to UK companies outside of the FTSE 100. We also believe many UK equity trusts currently offer a number attractions including decent yields, sizeable discounts and relatively low market P/E [price-earnings] valuations.’

Other UK trusts the analyst was positive on in a noter earlier this week were Edinburgh (EDIN ), Fidelity Special Values (FSV ), Law Debenture (LWDB ) and Schroder Income Growth (SCF ).