Companies that pay out their earnings to investors rather than reinvesting them are more often than not among the best performers over the long term, according to the Merchants Trust’s Simon Gergel, even though such stocks have fallen out of favour more recently as growth has dominated.
Gergel – who is also chief investment officer for UK equities at Allianz Global Investors – said it has been “quite an extreme time” for markets, with valuations at interesting levels, although he conceded that it has been difficult for the value style.
Performance of style indices over 10yrs
Source: FE Analytics
“Value investing has been under a lot of pressure but I think there are huge opportunities today,” he said. “As value investors, we believe you can have your cake and eat it: you can get a better income and a better total return.”
Gergel said the case for his income focus remains stronger than ever, particularly at a time when investors have been flocking to higher growth stocks that typically reinvest their earnings.
“If a company pays lots of money to shareholders each year, is that going to be better than a company that retains the money in the business and reinvests it?” he asked.
“You might think that companies that keep the money in-house and reinvest it will generate better long-term returns.”
However, Gergel said there is little evidence to support this viewpoint and over the long-term companies that pay out their earnings are likely to generate stronger returns.
“If you take, for example, the UK, if you’d bought the average higher yielding stock you would have outperformed the lowest yielding stock by about 3 per cent per annum over 40 to 41 years,” he said.
“Which is really quite a remarkable result in terms of compounding. It may not sound a lot, but over such a long period it’s significant.
“This effect isn't just over the long term, it’s actually happened since the year 2000. And it hasn't just happened in the UK. It’s happened in the US and has happened in pretty much all the major markets.”
He added: “We never buy a share because it has got a high yield, we buy a share because of the total return. The income might be part of that but it’s never the only answer.”
In addition, valuations in the UK remain compelling, according to the fund manager, compared with other markets on a cyclically-adjusted price-to-earnings (CAPE) basis.
“In the UK you’re paying about 14x [CAPE], which is below the long-term median in the US,” he said. “But, more importantly, it’s far below pretty much every major market in the world. It’s even below the average of the emerging markets.
“In a world where many markets are actually quite expensively valued, the UK is quite cheap.”
One of the main reasons for cheaper valuations compared with the rest of the world has been the ongoing uncertainty caused by Brexit, which has dogged the domestic market for three years.
Since the June 2016 vote to depart the EU, the FTSE All Share has risen by just 28.57 per cent compared with a rise of 53 per cent for the developed markets-focused MSCI World index, in sterling terms.
Performance of indices since EU referendum
Source: FE Analytics
“Brexit has caused investors to take money out of the UK even though about two-thirds to three-quarters of the sales and profits of British-listed companies come from outside of the UK,” said the Merchants Trust manager.
“So, it’s a great opportunity to buy UK shares because you’re getting exposure to global markets when they’re at really interesting valuations.”
Gergel said UK stocks are also offering attractive yields relative to their peers and have only really been higher during the tech bubble earlier in the century.
And, low valuations and volatility in markets last year have prompted the manager to become more active with the portfolio.
“Every day we see some big anomaly in the market and that's why we've been quite active in the last year, really taking advantage of those opportunities,” he said.
Despite the ongoing Brexit negotiations and the uncertainty it has caused, Gergel remains positive on the outlook for UK stocks, noting that there is also significant upside potential if a deal is struck.
Consumer spending remains robust, he said, as unemployment has dropped and there has been anecdotal evidence that companies are holding back off investment until there is greater clarity on the Brexit outcome.
In addition, the Allianz manager said there are some tools still available to UK authorities to help stimulate the economy should a ‘hard Brexit’ be settled upon, such as low interest rates and more government spending.
Gergel said the trust looks at three things when considering a stock: fundamentals of the business, cheap valuations, and a supportive macroeconomic thematic environment.
While the first and second attributes assess how robust a company is, the third considers the longer-term investment opportunity.
“We're in a dynamic world and that's where we put a lot of emphasis on understanding the long-term trends: they might be demographic changes or they might be technology changes,” he said.
“We try to buy companies where those are favourable. But of course, sometimes there are unfavourable trends in businesses and we spend a lot of time discussing and analysing those.
“Two or three years ago, you may remember there was a lot of discussion about peak oil.
“Some investors were saying, ‘well, demand is going to peak and these companies are structurally challenged’, and the valuations were bottoming out.
“We thought ‘Yes, the valuations are going down. Yes, ultimately oil demand will decline, but some very, very long way in the future. And in the meantime, the companies are going to generate a lot of cash and become more efficient’.”
Gergel added: “So those types of issues we did discuss, there are clearly companies in the portfolio, companies where there are open debates about the future of those industries. And those are challenges and you have to take a balanced assessment of those.”
Since Gergel took over management of Merchants Trust in April 2006, it has made a total return of 110.02 per cent against a 110.94 per cent rise from the FTSE All Share benchmark and a 92.44 per cent gain for the average IT UK Equity Income peer.
Performance of trust vs sector & benchmark under Gergel
Source: FE Analytics
The trust has a dividend yield of 5.3 per cent, is 17 per cent geared, is trading at a premium of 1.5 per cent to net asset value (NAV) and has ongoing charges of 0.59 per cent.