A move away from large-caps towards a more diversified portfolio has helped the Merchants Trust turn around its fortunes over the last 12 months. 
Last year the investment trust moved its benchmark from the FTSE 100 to the FTSE All Share to better reflect manager Simon Gergel’s transition towards more mid-cap stocks.
“Over the last decade we have moved from having about 10 or 11 per cent outside the FTSE 100 to about 35 per cent,” he said.
“This is partly because if you look at the opportunity set of high yielding shares it is a bit restrictive in the FTSE 100 – it is very concentrated – whereas the All Share gives you a broader opportunity set.”
List of top dividend payers in the UK in Q2
Source: Capita Dividend Monitor
Indeed, as the above shows, the top five dividend payers in the UK account for some 35 per cent of the overall market payouts, while the top 15 account for 83 per cent of total dividends.
“The directors wanted to reflect the fact that we are trying to deliver a higher and growing yield but we wanted to have that diversification effect to balance the risk,” Gergel said.
“Having around a third in mid caps is a bit higher than the index’s 15 per cent but we are not necessarily structurally overweight mid caps – if we can find the best value there we will have a bias and whilst I like the FTSE 100 shares a lot there are a number that look expensive or don’t yield enough.”
Overall, the trust’s large-cap exposure has come down from around 90 per cent 10 years ago to 59.7 per cent at the end of July 2017.
However, he noted that the trust is unlikely to fall below a 50 per cent exposure to the FTSE 100, as he remains structurally a large-cap manager.
“We do say that we are predominantly large-cap investors, so I don’t think we would go below 50 per cent. We’ve always had more of a bias to large cap than some of our competitors and actually I see a lot of value in certain mega caps,” the manager said.
One such example is UK domestic bank Lloyds, which the manager said has been hit very hard because it is a domestic bank.
“We have owned a big position in HSBC for some time and that has performed really well – it has gone from a yield of 8 per cent to a yield of 5 per cent and we feel that is starting to get more fully valued,” Gergel noted.
“It has a good presence in Asia but it still a UK bank and what is interesting is when you compare it to Lloyds, which is 100 per cent UK, it owns a higher return – it is more profitable – but it doesn’t have that diversification benefit.
“Our view is that Lloyds is coming out of a very difficult period, they’re starting to pay good dividends again now, they are starting to become reliable profit generators (at least at the operating level) and they are trading at just over book value.
“The big risk out there is the macro one. If we do have a sharp downturn – and it certainly looks like the UK is slowing down – I think Lloyds should be relatively well protected compared to other banks.
“But they have not been as aggressive in gaining market share into the downturn while some of the challenger banks have been more aggressive and I think Lloyds is quite conservative as a bank. Bearing in mind they are making a mid-teens return that is actually quite attractive.”
However, the move to a more all-cap approach has benefited the trust in the short term, which has been a top quartile performer over the last year, as the below shows.
Performance of fund vs sector, benchmark and FTSE 100 over 10yrs
Source: FE Analytics
Indeed, it has returned 19.04 per cent in the last 12 months, 7 percentage points ahead of the FTSE 100 and 6.73 percentage points ahead of the FTSE All Share.
Despite the change to a more all-cap approach, Gergel highlighted that the investment process behind the trust has remained largely unchanged, focusing on bottom-up stock selection than top-down macroeconomic predictions.
“I can’t tell you what the market is going to do in the next six months – I don’t think anyone can really,” he said.
“[However] we do take account of macro to the extent that it is going to affect the types of shares that you want to own in the portfolio.
“So there will be certain points in the cycle where you want to own one type of company such as leveraged companies including banks and financials and there will be certain points where you don’t.”
Any macroeconomic stances he takes therefore must be backed up with fundamental valuations and the opportunities at the company level, meaning that there is less risk if there is an unexpected event.
“I would say that calling the macro is very difficult,” the manager noted.
“Calling the individual companies is a much easier proposition particularly because you can diversify the portfolio over 40-50 companies whereas calling whether there is going to be a recession or not is a binary outcome.
“So unless we have a particularly strong call on the economy it normally won’t override the portfolio and the stock selection.
“We tend to think about different scenarios – what happens if something happens – and what is priced in today,” he added.
“At the moment, a lot of UK domestic companies are very lowly-rated and there is a considerable amount of uncertainty priced into that or, if you like, a considerable slowdown in the economy priced in.”
This has been the case since the Brexit referendum in June last year, when mid caps were sold-off heavily for fears of a slowdown in the domestic economy.
Indeed, the FTSE 100 has outperformed the FTSE 250 index by 4.63 percentage points since the referendum, as the below shows.
Performance of indices since the EU referendum
Source: FE Analytics
“The market is probably not pricing in a sharp recession but in some cases share prices are pricing in a mild downturn and that is interesting because if we don’t get that of course then the shares could perform very well.”
One such stock the manager has bought recently is the FTSE 250 company Greene King, which is down 19.32 per cent since the EU referendum in June last year.
“Greene King has had a progressive dividend policy for 60 years – so they have held or grown the dividend every year for six decades,” Gergel said.
“They are predominantly food-led these days rather than drink-led and I think that eating out is a trend that is going to continue to grow over time.
“I think long term there is no issue with Greene King – it has a strong balance sheet though it has quite a bit of debt but they can pay that down a bit every year.
“They are now trading at the lower end of their valuations – about eight times EBITDA with a 5 per cent dividend yield and they generate plenty of cash and we think that is good value on a medium-term view.”