A value view: The Merchant's Trust plc

Jon Cronin: Hello, and welcome to A Value View from The Merchants Trust, where fund manager Simon
Gergel, offers his thoughts on developments affecting the UK market and what it means for investors.
Simon, welcome to the show.

Simon Gurgel: Hi, Jon, good to see you again.

JC: It’s great to have you with us, there’s a lot to talk about. I’d like to get your thoughts on the outlook for the UK’s major exchange, the FTSE 100, because headlines suggest the picture looks mixed.

The FTSE hit an all-time high in February on the back of bumper profits for several of its constituent stocks, but there are growing fears for its future growth prospects after two major UK companies, ARM Holdings and CRH, announced their intention to list in New York. London’s share of international IPOs is clearly falling, so what’s going on here Simon? What’s your take on the FTSE 100’s current state and, more importantly, its future?

SG: It’s a great question and best answered in two parts. First, you’re right, FTSE 100 hit a record high in February, but it’s not been a great index; it’s been up and down a lot, but pretty flat for most of the century. It may be unnoticed, but the UK was one of the best performing major markets last year, because of its mix of companies.

We have a lot more companies in oil and gas, in mining and the banking sector: all areas that benefited from higher inflation, higher interest rates and high commodity prices. The UK market has less high growth, high technology stocks, which had a pretty tough year. The UK performed well despite what’s been going on elsewhere, but it came from a very low valuation, and valuation is often a determinant of long-term returns. The second question, regarding the future and why companies are leaving the UK, I think comes back to this valuation point.

Companies naturally look at their share prices and say: why do we trade at a low valuation in the UK? Would we get a higher valuation in America? It’s not just the UK that’s suffering; German company, Linde, is moving from the DAX 30, to a main listing in the US. And you know, CRH is not the first company to talk about it; I’m happy to go into what’s happening there.

JC: Yeah, I would like to dig a little deeper because it raises questions about the future for the exchange; tech is likely to be a key component in future, and the FTSE looks very underrepresented there.

SG: Again, there are two things to talk about; the low valuation, and the structure of the market. The UK has some of the best standards of corporate governance and stewardship in the world, which delivers great protection for investors. The flip side is it makes if more difficult for innovative, high growth companies to float and for founders to retain control; control is, of course, the opposite of stewardship.

A minority investor wants good governance and control in case the management does something you don’t like, or not in your best interest.

If you have dual share classes, which are common in America, founders can have far more votes than their shareholding would normally entitle them to. The UK has been reluctant to embrace this, but how do you encourage high tech, high growth companies to float in the UK, yet retain the right level of control and governance?

JC: Is there any appetite to change the rules here in the UK?

SG: There’s definitely appetite from government to encourage more companies to list in the UK; regulators want to do what they can, whilst being mindful of investor protections.

Investors are torn, because yes, we’d like the UK to be a more dynamic, larger market, but we have a duty to our clients, to be able to hold companies to account.

It’s really complex.

Then there is the valuation; for all sorts of reasons, the US market trades at a big valuation premium to other world markets around the world. CRH is interesting, because along with other companies, it moved from Ireland to list in the UK for the same reason - to get a better rate, larger market. So the UK has benefited in the past, but now we are seeing one or two companies move to the US.

JC: That’s interesting – so in future, will companies shop around for an exchange that will value them as they wish to be?

SG: It’s possible; hopefully, these pricing gaps will narrow and change over time, and it’s partly to do with the investor. Pension funds have sold down from owning 40% of the UK market a few decades ago, to about 4% today; historically the biggest investors in the UK, are now pretty marginal.

That can only go so far, and as the marginal investors or the companies themselves are taken over or approached elsewhere, that should lead to the valuations of shares starting to go up. If the big holders have effectively stopped selling, the remaining buyers should push the prices up.

I’m hoping for arbitrage, a normalisation of prices over time, which will remove the pressure to move exchange to get a higher rating, and possibly US valuations might come down. So at the moment it’s an issue; whether it remains an issue in five years’ time is an open question.

JC: What are your thoughts, more broadly, on the economic picture for the UK, which seems equally mixed? The International Monetary Fund has been notably negative on Britain’s outlook, yet recent data suggests the UK economy actually grew in January – only by 0.3%, but it’s still growth, and going in the right direction. Will this have much impact on market sentiment or is it priced in already, do you think?

SG: It’s not solely a UK phenomenon; growth has bettered some pretty gloomy forecasts in other big economies as well. It’s encouraging that the UK avoided recession, but it’s a double-edged sword.

Interest rate expectations had been coming down since the Kwasi Kwarteng budget, as people worried about growth and the outlook, and how far interest rates might rise.

If the economy is actually not that weak, then interest rate expectations could go up again. But it’s generally good news that the economy isn’t contracting, and you see that in the labour market, we’re not seeing rafts of job losses. Actually, we’re seeing quite good wage increases coming through, so the outlook for the consumer might be improving, which is encouraging.

The Bank of England and other central banks have to tread a narrow line between slowing the economy to control inflation, yet allowing enough growth to avoid a deep recession; so far they’ve done OK, but it’s a very difficult balancing act.

JC: It’s certainly a tightrope walk. Perhaps a greater impact on sentiment will be the reopening of China’s market following the Communist Party’s strict COVID-19 restrictions; surely this is good news, Simon - China back open at the heart of the global economy again?

SG: Yes, it’s good for world trade and good for the supply of goods; companies had all sorts of issues when they couldn’t get products out of China. It’s a boost to demand for commodities in particular; China was a very difficult area in terms of growth for last year, and this should be helpful for the global economy, although we have to watch the inflationary risk if China’s buying lots of energy, oil and gas and so on.

JC: And what of your FTSE 100 investments; we’ve discussed how the FTSE is much more globally focused, so the oil and gas companies, the banking companies and others as well, surely this is good news for them?

SG: Yes, absolutely; we have many multinational companies. They tend to be more regional multinationals, if you like, rather than companies that are necessarily importing goods from Asia to the UK. But, yeah, a stronger economy is definitely helpful.

JC: If you’re an Australian miner, you’re probably quite pleased that China’s back open again.

SG: Oh, absolutely. The iron ore price, for example, has gone up significantly from where it was a few months ago.

JC: Finally, your thoughts on the portfolio itself, where you see the current best opportunities for a value investor, Simon?

SG: Well, the UK market is very lowly priced, and quite diverse; many companies are trading well below the average valuation, so it’s a great stock-picking environment, and we’re finding opportunities across a whole raft of sectors. It’s hard to say which is the most interesting.

Some areas that performed well last year – like energy, like banks – look pretty resilient. We’re pretty optimistic about the outlook for energy and banking sectors, but also more domestic orientated areas.

The building construction area has lots of shares that are quite depressed; the economic outlook is more difficult, the housing market’s under pressure, but companies are pricing in a lot of bad news, and on a three-to-four-year view, that looks really interesting in terms of good value today.

There are also opportunities in more defensive areas, utilities, pharmaceuticals, where profits should be more resilient. I would say there are opportunities across the market in different sectors. It’s much more about individual stocks, and individual opportunities, and that’s great for a stock picker - we can see value across a range of sectors in different companies.

JC: As ever, Simon, it’s about getting under the skin of the business and understanding where the real value might be.

SG: Yeah, absolutely. We are stock pickers, fundamentally. It’s much more important to us that we find a good company with an attractive valuation and supportive end market dynamics, than if we try and predict where the macroeconomic outlook is going to go.

That’s incredibly difficult to predict, and also very hard to work out how that’s going to affect share prices as well.

JC: Well, sadly, Simon, we’re out of time, but it’s always a pleasure. Thank you very much indeed for that update and for your thoughts.

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, and until next time, from all of us here at The Merchants Trust, it’s goodbye.

Find out more about The Merchants Trust here >

by going to merchantstrust.co.uk.

In his latest short update, Simon Gergel looks at recent 2022 financial year reporting which contained some of the major dividend announcements from UK companies. Given the economic backdrop, what is the picture that’s being painted for the outlook for dividends from companies in the UK market?

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