Poor returns a high price for Merchants Trust's income

Merchants Trust (MRCH), which offers an attractive yield of 5.6 per cent, looks like an example of this. It has increased its dividend for 34 consecutive years, with the total payment of 24p in its last financial year an increase of 0.8 per cent on the year before, and fully covered by earnings. The trust can also use call options to enhance its income.

However, Merchants' share price underperforms the Association of Investment Companies (AIC) sector average over one, three and five years, and it is one of the poorer performers among its peers.

Its share price underperforms its benchmark the FTSE 100, as well as the FTSE All Share, over one three and five years. And in net asset value (NAV) terms it underperforms them over one and three years. Gearing of 18 per cent is one of the highest levels among UK Equity Income trusts, totalling around £76m at book value and £98m at market value as at 31 July 2016. This is in two tranches which have expensive interest rates of 11.125 per cent and 9.25 per cent. The first line of this matures in January 2018. "This is an important development although the fixed rate loan with a coupon of 9.25 per cent will not be repaid until May 2023," says Alan Brierley, director, investment companies team, at Canaccord Genuity.

Merchants' manager, Allianz Global Investors, explains that the trust's board considered paying off the debt early a few years ago, but both debentures have a so-called 'spens clause' or an effective spens clause meaning that it wouldn't be cost effective to do this. Under a spens clause the borrower has to value the cash flows beyond the date of its proposed redemption at the government bond yield, or some other low rate. This potentially makes it prohibitively expensive to take an early redemption.

Mr Brierley also points out that Merchants' five year compound annual dividend growth (CAGR) rate of 1 per cent is below its peer group average of 3.4 per cent. "The dividend was covered in the last financial year, although coverage has been a struggle in recent years; the allocation of costs and expenses is 65 per cent capital/35 per cent revenue," he adds.

The trust still has its attractions. As well as a high yield and growing dividends, its focus on well financed, global mega-cap companies with strong franchises may be attractive following the vote for Brexit, as these are less likely to be affected by any slowdown in the UK economy.

Allianz says the reasons for the recent underperformance include the trust being underweight mining which had a sharp recovery and overweight mid-caps which lagged the FTSE 100 significantly, but that that the first two factors were positive drivers in previous years.

The trust's manager, Simon Gergel, is also trying to improve performance and holds recovery situations such as businesses with strong market positions and competitive advantages, which are cyclically depressed or have had specific operational problems. "There is a potential to make high returns from these companies as profits recover, examples being First Group (FGP), Marks & Spencer (MKS), Balfour Beatty (BBY) and SThree (STHR)," explains Melissa Gallagher, head of investment trusts at Allianz Global Investors.

And the trust has a very low ongoing charge of 0.58 per cent.

However, it is possible to get such exposure and attractive dividend streams, as well as better performance via other funds including very cheap passives such as iShares UK Dividend UCITS ETF (IUKD) which yields 5.94 per cent.

And there are many examples of active equity income funds which have outperformed relevant indices in this week's Big Theme, as well as equity income investment trusts such as Diverse Income Trust (DIVI) or Finsbury Growth & Income (FGT).

So as you can do better than Merchants Trust and still get an attractive yield, it is probably not worth holding. Sell.

Source: Morningstar, *Allianz Global Investors

Performance

Source: Morningstar as at 12 August 2016

TOP TEN HOLDINGS as at 31 July 2016 (%)

Sector breakdown (%)