Mercantile Investment Trust plc (LON:MRC) has announced its annual financial results for the period ended 31st January 2024.
Highlights
· The Company’s net asset total return, based on debt at par value, was +4.5%; with the debt at fair, the return for the year was +5.4%; and the total return to shareholders was +6.1%. The Company outperformed its benchmark, which returned +1.8%.
· In the ten years ended 31st January 2024, the Company has generated an average annualised return of +6.1% per annum on a net asset total return par value basis, and +6.4% in share price terms, comfortably ahead of the benchmark’s average annual return of +4.5%.
· The Board has declared a fourth quarterly interim dividend of 3.30p per share. This brings the total dividend for the year to 7.65p per share, an increase of 7.0% over last year. On an annualised basis the dividend has grown by 6.7% per annum over the last ten years.
· The Company’s discount fluctuated between 9.7% and 16.7% during the period under review, but ended the year at 12.6%, in-line with where it began a year ago.
Angus Gordon Lennox, Chairman, commented:
“Despite [a] generally unsupportive environment, most of the Company’s portfolio holdings continued to do well at an operational level, and I am pleased to report a positive performance from the Company over the year under review, on both an absolute and relative basis.
Existing portfolio holdings have been performing well despite the challenging conditions of the past year and should do even better as and when the economy strengthens. In addition, the current very attractive valuations mean new investment opportunities among mid and smaller cap stocks are numerous, and the Portfolio Managers’ track record attests to their ability to identify and capitalise on the most compelling of these opportunities.”
Guy Anderson and Anthony Lynch, Portfolio Managers, commented:
“This has been a rather testing year for the UK market, with the direction of travel being driven to a major extent by the path of inflation, the actions of the Bank of England, and the impact of these upon expectations of future economic growth.
Performance this year was aided by a strong outturn from several of our longer-standing investments, led by our substantial holdings in the investment banking and brokerage services sector.
Portfolio turnover has remained somewhat lower than long-term averages, reflecting what we believe to be a resiliently positioned portfolio and our clear focus on the long-term prospects of holdings.
We are excited by the investment opportunities that [a] combination of low valuations, improving economic indicators, and strong performing portfolio companies yields. This backdrop explains our elevated level of gearing, which at the date of this report is approximately 15%. This is the highest level of gearing that we have applied in over a decade, which hopefully demonstrates most clearly our assessment of the opportunity before us.”
CHAIRMAN’S STATEMENT
Market Background
UK equity markets spent most of the past year worrying about stubbornly high inflation, the Bank of England’s determination to restrain inflation pressures by tightening the monetary policy reins, and the risk this posed to economic activity. However, market sentiment improved somewhat towards the end of the year as inflation began to slow and investors started to foresee interest rate cuts during 2024. Nonetheless, there remains a degree of negativity priced into the market at current levels. A lack of clarity about the path of interest rates and economic outlook weighed more heavily on medium and smaller cap companies than on larger cap stocks, given that smaller businesses are usually more vulnerable to rising interest rates and economic downturns. As a result, mid and small cap stocks are trading at historically wide discounts to larger caps, giving rise to opportunities for your Company.
Performance
Despite this generally unsupportive environment, most of the Company’s portfolio holdings continued to do well at an operational level, and I am pleased to report a positive performance from the Company over the year under review, on both an absolute and relative basis. For the financial year ended 31st January 2024 (FY24), the Company’s net asset total return, based on debt at par value, was +4.5%; with the debt at fair, the return for the year was +5.4%; and the total return to shareholders was +6.1%. The Company showed good outperformance against its benchmark, which returned +1.8%.
The Company’s average annualised return over ten years ended 31st January 2024 was +6.1% per annum on a net asset total return par value basis, and +6.4% in share price terms, comfortably ahead of the benchmark’s average annual return of +4.5%. This long-term track record of high absolute returns and outperformance of the broader small and medium cap market attests to your Portfolio Managers’ skill at identifying this sector’s future market leaders and outperformers.
The Portfolio Managers’ Report below discusses recent performance and portfolio changes in more detail, as well as considering their outlook for the coming year.
Returns and Dividends
The Company aims to provide shareholders with long term dividend growth at least in line with the rate of inflation over a five-to-ten-year period, as detailed in the table below. The Company has paid three interim dividends of 1.45p per ordinary share in respect of the year to 31st January 2024 and the Board has declared a fourth quarterly interim dividend of 3.30p per share. This brings the total dividend for the year to 7.65p per share, an increase of 7.0% over last year.
| CPI | Mercantile Dividend Growth | |
| (% per annum) | (% per annum) | |
| Three Years | 6.0% | 4.5% |
| Five Years | 4.1% | 4.0% |
| Ten Years | 2.8% | 6.7% |
Source: Office of National Statistics/J.P. Morgan.
In deciding the Company’s dividend payments during normal market conditions, the Board looks to pay dividends that are at least covered by current year earnings, while also allowing the Company to build revenue reserves. However, it is a great advantage of the investment trust structure that the Company has the option to partially fund dividend payments from revenue reserves, when necessary, to bolster the dividend during challenging times. The Company utilised this option in the three financial years FY20, FY21 and FY22. Then, having weathered these ‘COVID years’, total dividends for FY23 were fully covered by earnings, and I am pleased to report this remains the case again in FY24. Revenues per share over the past year increased by 25.3%, to 9.01p, from 7.19p in the previous year. This means that the Company has been able to increase the FY24 total dividend by a healthy margin, while also adding a meaningful amount to its reserves, to support dividends in any future lean years. After payment of the fourth interim dividend, the Company will have revenue reserves of more than 6.5p per share (2023: 4.9p).
Discount
Although it fluctuated between 9.7% and 16.7% during the period under review, the Company’s discount of 12.6% at year end was largely the same as where it began a year ago. Your Directors recognise that it is in the interests of shareholders that the Company’s share price does not differ excessively from the underlying NAV under normal market conditions. With market conditions continuing to be challenging, in an effort to equalise supply and demand and support the share price, during FY24 the Board utilised the Company’s authority to buy back shares, repurchasing a total of 8,024,097 shares, at a cost of £16.5 million. These shares were purchased at an average discount to NAV of 12.7%, producing a modest accretion to the NAV for continuing shareholders.
The Board closely monitors the discount and market conditions and will continue to undertake share buybacks when it deems such action to be appropriate. My fellow directors and I therefore recommend that shareholders approve the renewal of the authority to repurchase up to 14.99% of the Company’s shares at the forthcoming Annual General Meeting, with repurchased shares to be cancelled or held in Treasury. The Board is again seeking shareholder approval to issue shares at a premium to NAV and to disapply pre-emption rights on any such issues. As with buying shares at a discount, issuing new shares at a premium to NAV enhances returns to existing shareholders and improves liquidity.
Gearing
It is the Board’s intention that the Company continues to operate within the range of 10% net cash to 20% geared, under normal market conditions. The Company ended the year with gearing of 13.4%, up from 9.5% at the same time last year. This is the highest level of gearing in over ten years, reflecting the Portfolio Managers’ positive outlook as discussed in their report.
Having gone into the downturn modestly geared – positioning which detracted from performance – the Board is especially keen to ensure that the level of gearing enhances the Company’s exposure to a market upturn.
The Company’s balance sheet and levels of gearing are regularly discussed by the Board and the Portfolio Managers. Gearing is achieved via the use of long-dated, fixed-rate financing, from several sources, consistent with the Board’s aim to ensure diversification of the source, tenure and cost of leverage available to the Company. The Company has in place a £3.85 million perpetual debenture and a £175 million debenture repayable on 25th February 2030, together with £150 million of long-term debt raised in September 2021 via the issuance of three fixed rate, senior unsecured, privately placed notes (the ‘Notes’). These Notes mature between 2041 and 2061 and were secured at a blended rate of 1.94%, at a time when interest rates were near their lows.
Marketing, Promotion and Shareholder Interaction
The Company continues to raise its profile with investors and potential investors, via targeted media and promotional campaigns, and ongoing interaction with national and investment industry journalists. It is the Board’s view that enhancing the Company’s profile will benefit all shareholders, by creating sustained demand for its shares, particularly from retail investors, where demand has grown steadily in recent years. We seek to undertake this promotional activity in the most cost-effective manner.
To further promote the Company to the broader investment community, the Manager follows an established marketing and investor relations programme targeting wealth managers, institutions and private client stockbrokers via video conferences, podcasts and in-person meetings.
The Board and the Investment Managers also maintain a dialogue with the Company’s shareholders via regular email updates, which deliver news and views, and discuss the latest performance. If you have not already signed up to receive these communications and you wish to do so, you can opt in via www.Mercantile-Registration.co.uk or by scanning the QR code in Company’s Annual Report & Financial Statements for the Year Ended 31st January 2024 (‘2024 Annual Report’).
It is the Board’s hope that these initiatives will give many more of the Company’s investors and potential investors the opportunity to interact with the Board and Portfolio Managers.
Board Succession
The Board comprises six Directors. There were some changes during the 2023 calendar year, as we welcomed Julia Goh on 1st January 2023, and said goodbye to Harry Morley, who retired from the Board in May 2023.
The Board can confirm that its current composition is compliant with all applicable diversity targets for UK companies listed on the premium segment of the London Stock Exchange. It is the Board’s intention that this will continue to be the case.
The Manager
The Board, through its Management Engagement Committee, monitors the performance of the Manager, JPMorgan Funds Limited (‘JPMF’) on an ongoing basis. It is the Board’s opinion that the Manager’s performance remains strong. Based upon this, having taken all factors into account, including other services provided to the Company and its shareholders, the Board is satisfied that JPMF should continue as the Company’s Manager and that its ongoing appointment remains in the best interests of shareholders.
Annual General Meeting
The Company’s one hundred and thirty eighth Annual General Meeting will be held at Trinity House, Tower Hill, London EC3N 4DH on Wednesday 29th May 2024 at 12.00 noon. In addition to the formal part of the meeting, there will be a presentation from the Portfolio Managers who will answer questions on the portfolio and performance. The meeting will be followed by a buffet lunch which will give shareholders an opportunity to meet the Board, the Portfolio Managers and representatives of the Manager.
Outlook
Interest rates are expected to begin falling sometime soon, and leading indicators are pointing to some strengthening in activity, so corporate earnings are also likely to improve over the coming year. These developments should add momentum to the recent upturn in market sentiment. The Board therefore shares the Portfolio Managers’ confidence in the prospects for mid and smaller cap stocks during 2024 and beyond.
The Company’s prospects are equally bright in our view. Existing portfolio holdings have been performing well despite the challenging conditions of the past year and should do even better as and when the economy strengthens. In addition, the current very attractive valuations mean new investment opportunities among mid and smaller cap stocks are numerous, and the Portfolio Managers’ track record attests to their ability to identify and capitalise on the most compelling of these opportunities. All this suggests that the scene is set for the Company to deliver further capital and dividend growth to shareholders as we head into the future.
We thank you for your ongoing support.
Angus Gordon Lennox
Chairman
11th April 2024
PORTFOLIO MANAGERS’ REPORT
Setting the scene: inflation and central banks
This has been a rather testing year for the UK market, with the direction of travel being driven to a major extent by the path of inflation, the actions of the Bank of England, and the impact of these upon expectations of future economic growth.
With high inflation and rapid, if belated, tightening of monetary policy, a deep and painful domestic recession was widely predicted. Confounding this almost uniformly negative sentiment, the economy continued to demonstrate more resilience than feared, leading the market to oscillate between bouts of optimism and then pessimism, although overall languishing for most of the year as we waited for the inevitable to bite.
While inflation in the UK had proven to be stickier than in most countries, some of this was simply mechanical due to time lags, and it began to moderate more substantially towards the end of 2023. This, combined with weakening economic indicators, gave the market a glimpse that perhaps the monetary tightening cycle could be nearing a turn, which then drove a sharp rally in UK assets through November and December. Despite this double-digit final quarter, for the year as a whole our target market of UK medium and smaller companies (the ‘Benchmark’) only managed a small positive return, of +1.8%.
Mercantile performance
Against this somewhat uninspiring backdrop, for the year to 31st January 2024 the Company delivered a return on net assets of +4.5% with debt valued at par, and +5.4% with debt at fair value, in both cases ahead of the Benchmark’s +1.8% return. This outperformance was driven by stock selection. Gearing, which averaged 12% over the year, was additive to performance on a gross basis but not quite enough to offset its costs, which are thankfully fixed in nature. This recent performance extends the Company’s track record of outperformance over the long-term: in the ten years to end January 2024, its NAV delivered an annualised total return of +6.1% with debt valued at par, and +6.6% with debt at fair value, again both ahead of the benchmark annualised return of +4.5%.
Performance attribution
For the year ended 31st January 2024
Performance attribution analyses how the Company achieved its recorded performance relative to its benchmark index.
| % | % | |
| Contributions to total return | ||
| Benchmark total return | 1.8% | |
| Allocation/Stock/Sector Effect | 3.2% | |
| Effect of Cash & Gearing | 0.5% | |
| Cost of Debentures and Senior Unsecured Privately Placed Loan Notes | -0.6% | |
| Portfolio Total Return | 4.9% | |
| Management Fees/Other Expenses | -0.5% | |
| Share Buy-Back/Issuance | 0.1% | |
| Cum Par Net Asset Value Total ReturnAPM | 4.5% | |
| Impact of Debt Valuation | 0.9% | |
| Cum Fair Net Asset Value Total ReturnAPM | 5.4% |
APM Alternative Performance Measure (‘APM’).
Source: JPMAM and Morningstar. All figures are on a total return basis.
Contributions calculated using an Arithmetic methodology.
A glossary of terms and APMs is provided in the 2024 Annual Report.
Spotlight on stocks
Winners
Performance this year was aided by a strong outturn from several of our longer-standing investments, led by our substantial holdings in the investment banking and brokerage services sector. Private equity group 3i continued to deliver better than expected sales growth thanks to Action, a retailer that now accounts for close to two thirds of its net assets, while the fund-raising and financial performance of Intermediate Capital, an alternative asset manager, remained strong despite a well-reported industry-wide softening in demand for such strategies.
Other portfolio highlights this year included our significant holdings in the software and computer services sector, in companies such as Bytes Technology, Softcat and Computacenter, which have benefitted from robust corporate demand for IT infrastructure. These companies have also seen gains in market share and there is scope for revenue to accelerate further as customers begin to adopt generative AI solutions.
Given the overwhelmingly bearish views of the prospects for the domestic economy, it was particularly pleasing to see a strong contribution to returns from our holdings in the household goods and home construction sector, led by our longstanding investment in Bellway but also from Redrow. The market had been quick to mark down these shares aggressively given their high economic sensitivity, but valuations had reached extreme levels, hence we increased our holdings materially, which was then well rewarded once the shares repriced more favourably as the probability of the most negative scenarios diminished through the year.
Losers
It is inevitable that not all our investments will be winners, and while this is a fact of life, it does not diminish from the frustration at times. Our holding in Watches of Switzerland, a luxury watch retailer, was our largest detractor this year by some margin. We had reduced our position size somewhat on the back of a moderating growth profile, but a move by their key supplier Rolex into retail, via the succession-driven acquisition of Bucherer, exacerbated market concerns. This was then compounded by a material profit warning, following weaker than expected trading over the Christmas period. 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, preferring to reallocate the capital elsewhere while continuing to monitor their progress.
Our investment in Future, the specialist media platform, also came under pressure as audience figures and thus revenue – particularly in their important consumer technology products offering – declined, leading to a reduction in expected earnings. In addition, fears around the potential impact of AI and third-party cookies changes, combined with a management transition, placed further downward pressure on the company’s share price. However, with the shares at an extreme valuation, which we do not believe gives fair credit to their Go-Compare price comparison website business, we remain shareholders, and with the new CEO now in place, we are monitoring progress closely.
Positioning the portfolio for future success
We target UK companies outside of the FTSE 100 Index that have significant opportunities for growth and which may be overlooked by other investors. We invest in the shares of companies that we believe possess the characteristics that may facilitate this growth, for example nimble business models that can innovate or disrupt their industries, or companies that occupy prime positions in rapidly growing markets.
Through the course of any individual year there are adjustments to the portfolio to reflect the changing environment, as investment hypotheses run their course or are proved invalid, or as share price moves present better opportunities elsewhere. Over the past few years there have been multiple turning points for markets as well as numerous changes to the operating environments of our portfolio companies. Despite this, portfolio turnover has remained somewhat lower than long-term averages, reflecting what we believe to be a resiliently positioned portfolio and our clear focus on the long-term prospects of holdings.
Furthermore, we have been operating in a volatile environment, with a pandemic and associated restrictions, supply chain challenges, surging then falling inflation, a drastic shift in monetary policy, war in Europe and the Middle East and an evident souring of East-West relations. We believe that this backdrop has made it even more important to focus on well-positioned and well-managed businesses that have the resilience to cope and even thrive in a variety of situations, and which may ultimately emerge with stronger competitive positions.
Over the last year there have been various changes to the portfolio’s constituents and thus its overall shape, and while some of these are reasonably material, it should also be read in the context of a portfolio in which over 80% remains unaltered. While these changes are all based on single stock investment or divestment decisions, from a top-down perspective these could be summarised by stating that the portfolio today has an increased exposure to domestic compared to international end markets versus one year ago, with even more technology-related holdings, and with an increased amount of capital invested in the housebuilders and in real estate more broadly.
In the software and computer services sector, we added to our investment in Bytes Technology, the aforementioned value-added technology reseller. We also made a new investment in Moneysupermarket.com, a price comparison business seeing increased demand due to higher insurance prices and where, now that their technology re-platforming is complete, there is scope to improve profitability by increasing direct-to-site traffic and cross-sell in place of pay-per-click.
As already explained above, we made additions to our housebuilding positions through the year, adding to the pre-existing positions in Bellway and Redrow, while also adding a new investment in Vistry.
Having previously had a very bearish view on the outlook for real estate more broadly, this has become more nuanced over the year, as many of the negative factors that we anticipated have played out and driven share price falls: valuations came under downward pressure through an environment of rapid increases to interest rates and thus the discount rates upon which property valuations are based. While we still maintain a significant overall underweight in this sector relative to the benchmark, we have moderated its size, and last year we started our initial foray back into this space, taking positions in some of the most attractive propositions, with investments in LondonMetric Property, Shaftesbury Capital and Tritax Big Box REIT, each of which we believe to be exposed to end markets that will deliver robust rental growth in coming years.
Other stock specific changes include a large increase in the size of our position in Hill & Smith, an infrastructure engineer. This comes in response to the company’s improving growth opportunity, driven primarily by an expansion of US infrastructure spending. We also made a new investment in Bodycote, an industrial engineer which should benefit from the continued post-pandemic recovery of the aerospace industry, and in Jet2, the airline and package holiday provider, which has benefitted from robust consumer demand, and which continues to generate market share gains.
These purchases were funded by various sales, including the previously mentioned Watches of Switzerland, a substantial reduction in the size of our position in RS Group, a distributor of electronics and industrial products, and exits from Pets At Home, a pet product retailer and services provider, and from Spirax-Sarco, our longstanding investment in a supplier of specialist industrial machinery, now a FTSE 100 company.
Outlook for the coming year
Financial markets continue to be heavily influenced by the inter-connected forces of inflation, monetary policy, and the impact of these upon economic growth expectations. While the domestic economy through the end of last year was undoubtedly lacklustre, and the UK may have experienced a recession, evidence thus far would suggest that this is more likely behind than ahead of us, and if so, it will have proven to have been far briefer and shallower than most were anticipating. Indeed, employment levels have remained resilient and following 13 consecutive months of real wage declines, the average consumer has now experienced over ten months of real wage growth. Coincident with this, consumer and business confidence indicators are pointing to an improving picture, which could lay the foundations for greater consumer demand, more business investment, and thus lead to a better environment for corporate earnings growth.
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. Within the UK, given their greater economic cyclicality and sensitivity to interest rates, mid-and small-caps are trading at a discount relative to their usual level versus large caps. Furthermore, portfolio companies have, for the most part, been performing well at an operational level, as demonstrated by a gradual, but notable, increase in earnings estimates over the year. Notwithstanding the obvious geopolitical risks that surround us, or those associated with around half of the world’s population – including the UK – voting in elections in the coming year, we are excited by the investment opportunities that this combination of low valuations, improving economic indicators, and strong performing portfolio companies yields. This backdrop explains our elevated level of gearing, which at the date of this report is approximately 15%. This is the highest level of gearing that we have applied in over a decade, which hopefully demonstrates most clearly our assessment of the opportunity before us.
We will maintain our focus on investing in structurally robust businesses that operate in growing end markets and possess the ability to invest capital at attractive returns and which can also adapt to the changing environments in which they operate. We believe that a portfolio of such investments offers the best prospect of delivering compelling returns and outperformance for our shareholders over the long-term, just as they have done in the past.
Guy Anderson
Anthony Lynch
Portfolio Managers, Mercantile Investment Trust
11th April 2024
