Retail banks and mining companies are two of the major potential value traps in the current UK equity market, according to Simon Gergel, manager of the Merchants Trust, who says though they look cheap, this is for very good reasons.
In an article earlier this week, Gergel told FE Trustnet that his approach to finding companies was not to look at areas of the market that are cheap, necessarily, but to assess how threatened a business is by changing structural or regulatory environments.The manager, who has run the popular Merchants Trust since April 2006, says one of the issues in the current market is that most sectors look expensive relative to their long-term averages and therefore investors may feel forced to just buy companies that are trading on low valuations.
He says this is a dangerous strategy and there are a number of cheap sectors that investors should think very carefully about before buying; starting with retail banks.
“We own HSBC, but I would say the domestic banks [are a potential value trap],” Gergel (pictured) said.
Leading UK retail banks such as Lloyds, Barclays and, to a lesser extent, Royal Bank of Scotland have become more and more popular with fund managers over recent years.
All three have nowhere near recovered since the financial crisis, as the graph below shows, but changes in management, low valuations and an improving UK economy have caused investors to tentatively dip their toes back into the sector.
Performance of stocks vs index over 10yrs
Source: FE Analytics
Some have been less tentative than others, however. Our data shows that there are 108 funds in the IMA universe that count Lloyds as a top 10 holding, 59 count Barclays as a top 10 holding while 10 hold RBS in their top 10.
The likes of Richard Buxton’s Old Mutual UK Alpha fund has Lloyds and Barclays in its top 10, while Alastair Mundy and FE Alpha Manager Mark Costar are among the managers who have a high weighting to RBS in their Investec UK Special Situations and JOHCM UK Growth funds.
Schroder Income and Jupiter Undervalued Assets are examples of UK funds that hold all three of the major retail banks, with the latter counting Lloyds, Barclays and RBS as top 10 holdings.
“They look reasonable value, but there are all sorts of issues out there such as capital needs, the poor state of the economy, uncertain regulations and tax and Mr Miliband talking about further banking levies,” Gergel said.
“The banking environment is still very difficult and it’s quite hard to be confident on the valuation of banks, so it’s one area where they potentially look good value but there are still a lot of risks.”
Gergel isn’t alone in taking a cautious view on the sector as FE Alpha Manager Neil Woodford recently told FE Trustnet why he now has no exposure to the UK’s banks.
Gergel is also negative on the mining sector as a whole.
“Again, valuations are starting to look quite interesting or at least the shares have come back a long way. However, you still have to be very confident about what is going to happen to the iron ore price and we are not,” the manager said.
Like the banks, mining companies had been massively out of favour with investors.
The economic slowdown in China causing falling commodity prices to fall, reckless capex and M&A activity along with an ill-timed increase in supply have all meant the sector has lost an eye-watering 35 per cent since January 2011.
Performance of indices since Jan 2011
Source: FE Analytics
However, ultra-low valuations, along with changes in management and a promise to repay shareholders, have meant many have started buying mining companies.
According to FE Analytics, 166 IMA funds hold Rio Tinto in their top 10, 128 hold BHP Billiton in their top 10 and 34 have Glencore in their top 10.
There are a high proportion of income funds in those lists with Old Mutual UK Equity Income holding both Rio Tinto and BHP Billiton and JOHCM UK Equity Income holding both Rio Tinto and Glencore.
One of the most extreme examples is the £20m Elite Charteris Premium Income fund, which counts Rio Tinto, BHP Billiton, Glencore plus other commodity related companies such as Antofagasta, Fresnillo and Randgold Resources as top 10 holdings.
Fidelity’s Michael Clark told FE Trustnet that, from an income perspective, he was particularly bearish on holding mining companies.
“Looking at it from an income perspective, the problem is that these companies mainly focus on iron ore production and they basically have one major customer, which is China. If the slowdown continues, then I think their price is at risk,” Clark said.
Gergel doesn’t think that their dividends are at risk, but he does question where management teams within the sector are going to deliver on their promise to become more shareholder-friendly.
“We own BHP Billiton, which is more diverse and has quite a large oil business, in particular, and therefore the dividends look safer.”
“Dividends across the sector look alright so I think we are a long way off a dividend cut for Rio Tinto, for example. However, whether you get cash back, which a number of investors have been looking for, is quite a big question now.”
According to FE Analytics, Merchants Trust has been one of the best performing portfolios in the IT UK Equity Income sector since Gergel has been at the helm.
It has returned 63.03 per cent, beating its benchmark – the FTSE 100 – which has returned 52.06 per cent.
Performance of trust vs sector and index since Apr 2006
Source: FE Analytics
The closed-ended fund has also beaten the index over three and five-year periods, but has underperformed over the last 12 months.
Gergel’s portfolio, as its benchmark suggests, is skewed towards large-caps with Royal Dutch Shell, GlaxoSmithKline and British American Tobacco featuring in his top 10.
However, he will look into the FTSE 250 if he finds decent opportunities. Merchants Trust yields 4.85 per cent and it has increased its dividend in each year since Gergel has been in charge.
The trust has gearing of 18 per cent and it is currently trading on a 1.3 per cent premium to NAV due, in part, to Gergel’s focus on finding a growing source of income.
While that is more expensive than its one and three-year average, Merchants has traded at a 3 per cent premium at times over the past 12 months. Its ongoing charges are 0.59 per cent.
