Merchants Trust: we yield 5% and will keep growing our dividends

Investing in high-yielding UK shares, Merchants Trust (LSE:MRCH)is a popular choice for income investors. Managed by Simon Gergel, it has racked up 41 consecutive dividend increases, and the trust has no intention of breaking its record.

Gergel speaks to interactive investor’s Sam Benstead about how he manages the portfolio, including his views on oil and tobacco companies and how it has managed to keep paying investors a rising dividend. He also speaks about where he looks for income opportunities, including which shares he likes at the moment.

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Simon Gergel, manager of the Merchants Trust. Simon, thank you very much for coming into the studio.

Simon Gergel, manager of Merchants Trust:Hello.

Sam Benstead: So, could you please tell me a bit about how you invest? What are you buying and what is the goal of the investment trust?

Simon Gergel: The Merchants Trust has been around for 133 years and the goal is to deliver a high and rising income stream along with a good total return, investing in UK equities, predominantly large-cap UK equities. We try to identify companies that we think can have three factors. We want companies that have strong fundamentals, a good business, strong competitive position, a strong balance sheet, a strong financial position and so on. We want companies that are cheap, compared to their history or compared to other companies we can buy. And then third, we don't just want good companies that are cheap, we want companies that ideally have a very supportive end market dynamic. We call it a theme, like a demographic change or the way digitalisation is affecting the industry. And if you combine that, if you can get a good company that's cheap, but with a supportive end market theme, that can be really quite powerful. If we build a portfolio of those companies with a good yield, hopefully we can deliver a good total return and a good income as well.

Sam Benstead:Is your aim to find companies that pay a high dividend today, or are you perhaps looking for companies that can grow their dividend?

Simon Gergel: It's a really good question. We yield just under 5%, so significantly more than the stock market in general. We try and buy companies that have a good yield, but we never let the yield drive the investment decision, if that makes sense. We always buy companies where we think we can make a good total return. So, we fish in the pond of high-yielding companies. But once we own them, we're not concerned whether that dividend in particular is growing fast or not growing much at all. We want to buy companies where we think we can make good money, and if we can make good money on the underlying company. Ultimately, we can either get dividend growth from that company, or we can reinvest the proceeds to get dividend growth elsewhere. So, we are much more focused on buying really good companies that are cheap, that we can make money in, than that every company in the portfolio has to grow at a certain rate. That's not our focus.

Sam Benstead:And the trust is an AIC dividend hero. That means it keeps raising its dividend and you've got a more than 20-year record of doing so. So, how many years have you been raising that dividend and how did you manage to do that during Covid where lots of the dividends actually weren't paid?

Simon Gergel: That's another good question. So, the trust has raised the dividend for 41 years, which is longer than I have been managing it, so my predecessor and me. And the way investment trusts are able to do this and have these really long-term records of raising the dividend is because the directors can take money in good years, when the sun is shining, put money in reserves and then draw on those reserves in the difficult times when it's raining to keep paying a growing dividend.

You're right, well before Covid, we were putting money away into reserves. The directors were putting money away every year. And then when Covid hit and income fell by a third for the first year, the directors dipped into the reserves to keep paying growing dividends. We've come through that now. Income has recovered in the market and the dividend was once again covered last year. So, we've got through that and we can start rebuilding those reserves again.

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Sam Benstead:So, how are those reserves right now? If we had another period where dividends dried up for whatever reason, would you be able to keep raising the dividend and that would be a real priority for you?

Simon Gergel: It is a priority to keep repaying a growing dividend, but not at the expense of the sustainability of the trust ultimately. But we have 16 pence per share in reserves at the end of the last financial year, which is about just over half of an annual dividend of about 27.5p, so you can see the still quite substantial reserve position there.

Sam Benstead:And where are you finding the best income opportunities today? What sectors are you investing in?

Simon Gergel: Well, we're finding opportunities across different parts of the market, both in domestic companies and international companies, because the UK stock market has a lot of international earners in some defensive industries such as pharmaceuticals or utilities. So, industries that aren't particularly sensitive to the economic cycle, but also in the more cyclical areas. I think given how nervous the stock market is and how polarised it is, you have a big gap in valuations, so we're finding particular value today in some of the more economically sensitive areas such as housebuilding, building products, consumer services, and retail.

We're finding some really interesting bargains in those areas because a lot of investors are shunning those areas and shares might be out of favour and we can find some companies that are really strong businesses on a two-three year view. They're going to go through a difficult time, some of them, and that means that the shares are offering really good value in many cases. So that's where we [are finding] the best value today, those more cyclical, more domestic areas, but there are opportunities across many of the sectors, other areas I could touch on, banks, energy companies, they all look good value as well.

Sam Benstead: Let's go back to those cyclical bargains. Which types of companies are you buying and what are the yields on offer today?

Simon Gergel: We've bought quite a few companies that make building products, everything from bathroom showers and taps to roof tiles and paving stones and, in fact, doors and components for doors and windows. Yields typically can be 4%, 5%, 6%, they can be higher, but they are generally quite high and profitability has been good. The companies are generally quite lowly priced. But the concern, of course, is that profits are going to come down because trading is going to be more difficult in those building, repair and maintenance industries. So, I think you've got to be a bit careful with looking at the valuation today in terms of the multiple, how much you're paying for the profits, because those profits might come back down. But if we look through the cycle and say, OK, in two to three years' time, as the industry recovers, the valuation multiples look really attractive, really sensible to us.

The other thing I would say is we know there's a shortage of housing in the UK. We need to build more homes. So, at some point in the future house building will pick up again. And many of the companies are global, so [some have] got operations in Ireland, and a lot of them in America have big operations. And the markets are different there, different cycles, different opportunities.

Sam Benstead: So, which specific companies do you like in the building and housebuilding space then?

Simon Gergel: Well, we've got companies like Grafton Group Units (LSE:GFTU), which is a distributor of building products. It's got a leadership position in Ireland, in DIY and also in builders’ merchants, but it owns the Selco brand in the UK, which you might know of. We've got a company called Norcros (LSE:NXR), which makes bathroom tiles and showers, taps, those type of products. It has consolidated some quite fragmented markets, it has got some really strong brands. We've got a company called Tyman (LSE:TYMN), which has got a very large presence in America, it's the market leader in making components and doors and windows. The balance is when you have a double-glazed window, the locks and the bits of metal, the hardware that go round it. They've got a very strong 40% market share. We're quite optimistic about the US housing market. So, there's a number of companies in that area.

Sam Benstead:You own Shell (LSE:SHEL) and BP (LSE:BP.) The oil and gas sector is important to you. Why did you like that area and are you worried that falling oil prices linked to economic concerns globally, especially in China, will impact their ability to pay dividends?

Simon Gergel:Well, interestingly, we had a meeting with the chief financial officer of Shell this morning in our offices, the businesses are generating a huge amount of cash at the moment. The oil price has come back, as you say, from where it was. But Shell believes it can cover the dividend even at $40 oil. The oil price is currently about $70. And we are relatively positive about the outlook for oil and gas prices in the medium to long term, particularly because there's so little investment going in.

There's a natural cycle in oil that normally when prices go up, investment goes up in the industry, more resources are brought to the market and the price then falls because the market has lots of supply. That hasn't happened this time around. Most companies have held back their investment, are focused on cash generation, and demand/supply is pretty tight. And so, yes, there might be a short-term drop in the oil price because the economy is weak, but medium to long term there's not going to be enough hydrocarbons probably, and the prices are likely to remain firm.

And clearly we saw that the tragic invasion of Ukraine last year with Russia pushed the gas price up hugely in Europe. And I think there are still going to be shortages for the next two or three winters because of that. So, I think we're quite positive on the outlook for oil and gas prices, but certainly for the companies that are generating very strong cash flows on the back of it.

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Sam Benstead:Tobacco is another sector that you like, a bit like oil, some investors steer clear of it. But why is it great for dividend seekers?

Simon Gergel:I'd have to give you a very long answer on this one potentially, but in essence, these companies are generating a huge amount of cash. The number of people smoking every year is declining, but they're able to raise prices to offset that and keep growing the profitability. And at the same time, they're starting to build the next generation of products, which are less harmful, so vaping and heat-not-burn products.

The main problem [with] cigarettes is that the combustion of cigarettes creates a lot of bad chemicals, toxic chemicals, which are harmful. If you can take that burning out of the process and have vaping, or heat-not-burn, they may be less harmful products. And as the industry gradually repositions, they might become hopefully more sustainable, with products that are less harmful. But the other thing about tobacco companies is they are extremely lowly priced because investors are concerned about the sustainability of the business and how long these cash flows can be around for. We think the cash flows could be around for many years into the future, so we see a good opportunity there.

Sam Benstead:Another big investment sector for you is financials. We've seen interest rates hit 5% now in the UK, but the economy could be weakening. How do you assess what is a good financial stock to own for income?

Simon Gergel:Well, the first thing to say about financials is that it's an incredibly broad and heterogeneous sectors. We've got companies in there like IG Group (LSE:IGG), which is an enormously profitable spread betting company. We've got fund management companies, we've got banks, we've got insurance companies. They all often have different cycles and different factors.

If you take insurance, we're seeing very rapid rises in insurance premiums, which should be good for their profitability going forwards. Banks have been completely restructured since the financial crisis. They've got less debt, less leverage and stronger business models than they had previously, and they're generating lots of cash. So, we're finding lots of opportunities there. Interest rates rising is a double-edged sword for many financials. Often they benefit because they can make a better spread between the depositors and the lenders. But there's a risk as interest rates go up, there's a risk of bad debts picking up. So, you have to look, sector by sector or sub-sector by sector and even company by company. But we do find lots of opportunities in financials at the moment and interest rates going up is not necessarily a bad thing. In fact, for some of them, it's quite a good thing.

Sam Benstead:Simon, thank you very much for coming into the studio.

Simon Gergel:Thank you very much.

Sam Benstead:And that's all we've got time for. You can check out more Insider Interviews on our YouTube channel where you can like, comment and subscribe. See you next time.