Merchants yields 4.7 per cent, the highest income on offer from a UK equity trust over £100m, and Tan says it is well-covered and has a long track record of increases. “With a dividend yield of 4.7 per cent, we believe Merchants Trust is comfortably the highest yielding UK equity-focused investment company of significant size,” he said.
“The existence of high-yielding debentures in the company’s capital structure has had a negative impact on Merchant’s fair net asset value [NAV] in light of the current low interest rate environment.”
“However, with the passage of time, and the increasing probability of higher interest rates, this “pull to par” should begin to contribute positively to Merchant’s NAV, in our view.”
Merchants has taken out loans which mature in 2018 and 2023 with effective interest rates of 11.3 per cent and 8.3 per cent respectively.
These trade at a premium to par value, which means the size of the trust’s liabilities are higher than they would be and therefore the NAV lower.
Accounting for deb this way is thought to be more cautious, but the amount the trust will actually have to repay hasn’t changed.
Tan says that as the debt matures and as interest rates normalise the debt will trade closer to par and increase the NAV of the trust: this could be worth as much as 5 per cent of NAV, he estimates.
Merchants focuses on the FTSE 100, and has around 70 per cent invested in that index. It has lagged the sector over the past three years in share price terms.
It has, however, significantly outperformed the benchmark. In NAV terms it is middle of the pack over that period, but still well ahead of the FTSE.
Performance of trust vs sector and index over 3yrs
Source: FE Analytics
The major attraction of the trust is its yield. Tan notes that the £61m Manchester & London Trust is yielding 5 per cent and the £19m Investment Company 4.9 per cent, but of all the large and liquid trusts this is the highest-yielding.
It also has one of the longest track records of consecutive dividend increases, as calculated by the AIC.
The dividend has grown from 2.1p a share in 1982 to 23.6p a share in 2014, representing growth of 7.9 per cent a year.
Tan notes that this increase is more than double the average 3.6 per cent a year increase in the retail price inflation index.
The fact that the trust has revenues reserves equivalent to roughly the entire last year’s dividend gives extra security that there will be no reduction in future payouts.
The trust has been managed by Simon Gergel for Allianz since April 2006 and has low ongoing charges of 0.66 per cent.
Data from FE Analytics shows that it has outperformed the sector and benchmark over that time, returning 67.08 per cent in share price terms.
Performance of trust vs sector and index since Apr 2006
Source: FE Analytics
Its major holdings are in the traditional income-paying sectors: Shell, Glaxo, BP, HSBC and BAT are the largest five positions.
Many investors and analysts have highlighted the large cap sector as the most attractive in terms of valuations.
In fact 2014 has seen a rotation back into many of the defensive names popular with equity income funds such as Merchants.
The oil and gas sector has been tipped in particular, and makes up 15.8 per cent of the trust.
Performance of sector vs index in 2014
Source: FE Analytics
The trust is trading around par as it has tended to do over the past 12 months.
