Finding good value opportunities

Simon Gergel, Manager, Merchants

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There is an element of uncertainty on the economic outlook, as always.  Western economies are gradually recovering but growth is likely to remain modest.  Japan is struggling to grow and several emerging markets are in recession.  The UK stock market, however, is discounting many uncertainties.  Share prices have retreated and offer good value.  Furthermore, the disparity of valuations within the market has become notably greater.  Defensive businesses, such as food and beverages companies and regulated utilities, are generally expensive.  On the other hand, cyclical and financial stocks have fallen significantly, with some offering exceptional value.  As such, looking at the aggregate stock market valuation can be misleading.

We see good value in specific parts of the stock market but not others.  Certain “mega-cap” companies look particularly attractive; GlaxoSmithKline, HSBC, BP and Royal Dutch Shell, are lowly priced and out of favour.    Another area of the market we favour is recovery situations.  These are either industries where the outlook is improving, such as UK construction or companies where there is some sort of restructuring or turnaround strategy in place.  Examples include the retailers Marks & Spencer and Mothercare, and the transport company First Group.

Businesses offering structural growth are also attractive in an environment of low economic growth, but many are already highly valued within the stock market.  However, there are situations where we can find strong businesses with good growth profiles at sensible valuations.  These include Inmarsat, Brammer, SThree and Hostelworld.  In a similar vein, although there is a high level of uncertainty about the short term growth in emerging markets, we see structural growth in consumption in the developing world.  This will help companies in the portfolio such as Prudential, GlaxoSmithKline and United Business Media.

Many financial stocks also look attractive after recent weakness.  Life assurance companies, such as Standard Life and Legal & General offer high dividend yields and decent dividend growth.  The banking industry is emerging gradually from a substantial restructuring during the financial crisis.  Banks are now more tightly regulated, better funded and have higher levels of capital.  Lloyds, in particular, is now beginning to pay a healthy level of dividends after rebuilding its capital base.  We believe that banks should become more resilient than previously and, in time, this will lead to a revaluation.  Elsewhere within financials, we have investments in a diverse range of specialist businesses and industrial real estate companies.

There has been a considerable media focus on the risks to dividends at many of the large UK companies, especially in the natural resources sector, but the reality is more nuanced.  Within the Merchants portfolio, there are risks to certain companies’ dividend payments, but we also see good growth in many other dividends.  The four largest income contributors in the portfolio are the “mega caps” listed above.  All of these have recently maintained or raised their 2015 dividends and reaffirmed their dividend policies.  A material proportion of the portfolio had a very low historic yield at the end of 2015, with the potential to grow payments significantly in the future.  Furthermore, the recent weakness of the pound is also helping the Trust’s income stream, as it increases the sterling value of the many dividends that are paid in US dollars or other currencies.  Finally, investment companies, such as Merchants, have the ability to smooth dividends by tucking away reserves in good times to maintain pay-outs in tougher times.

In summary, with markets having retreated in recent months, we see many interesting opportunities to buy strong businesses with attractive dividend yields, trading on low valuations.