The managers of the £2.2bn Mercantile Investment Trust are betting on a strong UK market recovery and explain why they are overweight UK tech stocks in the mid and small cap space.
JP Morgan’s Anthony Lynch and Guy Anderson, who both manage the trust, target UK companies outside the FTSE 100 that they believe have significantly more room for growth, which is often not recognised by other investors.
“The most important thing for me is the greater potential for smaller companies to grow at a higher rate than larger companies,” Anderson said. “Ultimately, larger companies become limited by the underlying growth of their markets where it is the smaller companies who have greater scope for growth.”
Anderson also highlighted the different sectoral and geographic exposure of small- and mid-cap market compared to the FTSE 100, which is concentrated at both the stock and sector levels.
The FTSE 100 has high weightings to individual stocks, where a company such as AstraZeneca comprises over 7 per cent of the index, and it is heavily biased towards sectors such as financials, which make up almost 20 per cent.
“The mid-cap market, in contrast, is very well diversified,” Anderson said. “There's no single stock in terms of the universe that makes up much more than 1.5 per cent of that part of the market. It is also very well diversified by sector and doesn't have that same sort of concentration.”
He also noted the geographical exposure of the FTSE 100: “The FTSE 100 is not actually a reference point for the UK economy. It's extremely international in terms of the end markets.
“The revenue of the companies that make up the FTSE 100 is roughly three-quarters international and about a quarter domestic. In contrast, for both the mid- and the small-cap indices it's more like 50 per cent domestic and 50 per cent international.
“So, the mid- and small-cap is far more exposed to the domestic economy than the large-cap market.”
The manager has an optimistic outlook for the UK equity market but especially within the mid- and small-cap spaces due to the above characteristics.
“We've clearly had had a tough time through Covid-19,” he said.
“The UK economy has been hard hit from that and we've had that uncertainty of Brexit to contend with. But when we look forwards, I think both of those clouds will disperse and there will be potential for a really quite nice earnings recovery.”
Performance of the FTSE 100 versus the FTSE 250 over the last decade
Source: FE Analytics
One such FTSE 250 stock in Mercantile Investment Trust’s portfolio is Dunelm Group, the UK-based homewares retailer.
Anderson said: “One of the things that they have benefited from is there has been a change in consumer behaviour. There was a bit of a boom in terms of consumers spending their disposable income on items that would be used at home and home furnishings absolutely sort of falls into that category.
“They have benefited from that little boom but, looking at it on a on a longer-term basis, they've got a very strong position in the homewares market. It's an incredibly fragmented landscape in the UK, but they are one of the leaders.”
He believes what separates Dunelm from the competition is its very strong multi-channel capabilities, citing the recent roll-out of click and collect and move to its own hosted web platform with better functionality for search and checkout.
“That has really allowed for a huge growth in their online sales as a percentage of their total sales, which obviously has been crucial through the last year but also is crucial for any retailer going forward,” he explained.
Performance of Dunelm over 1yr
Source: FE Analytics
The manager continued: “Retailers which are purely bricks and mortar are clearly in a structurally challenged place, whereas this is a business that's really come through over the last year or two and become a true omni channel retailer.
“Their underlying organic revenue growth has really accelerated over the last couple of years. There have been ups and downs, but it has generally been on an improvement trajectory. I believe that as we as we look ahead to the next year or two as we come out of this Covid period, they will continue to benefit from those investments.”
Technology and software services firms, however, make up the largest overweight positioning in Mercantile Investment Trust’s portfolio, accounting for around 11 per cent, compared with 7 per cent from the average investment trust in the sector.
Anderson said the sector uses a very narrow definition of software and that there are a lot of firms that he considers technology businesses but aren’t officially classified as them, such as online car marketplace Autotrader and online media business Future.
“When I think the true technology exposure in the portfolio is significantly higher than that number,” he said.
Two of its largest technology holdings are IT firm Softcat, which makes up 2.8 per cent of the portfolio, and Computacenter, which makes up 2.9 per cent.
Anderson described Softcat as “a value-added technology reseller that targets small and mid-sized businesses as well as the public sector, a part of the market that has typically been under served”.
“It's a growing market and one where they're very well positioned to continue capturing market share, and when we look at the business performance, they have a really phenomenal growth track record,” he said.
“They have delivered positive organic growth every single quarter, for the last 15 years, and that is obviously a tremendous performance.
“It's pretty rare to find a business that has delivered such a stellar growth trajectory over such an extended period of time, and they clearly, in my mind anyway, well set to continue with that that strong track record,” he finished.
The Mercantile Investment Trust has returned 73.51 per cent over the last five years, compared to 53.37 per cent from the average peer in the IT UK All Companies sector and 43.87 per cent from the FTSE All-Share ex Inv Co benchmark.
Performance of trust vs sector & benchmark over 5yrs
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Source: FE Analytics
The trust currently pays 2.7 per cent yield and is trading at a 2.9 per cent discount to net asset value (NAV). It is 14 per cent geared and has ongoing charges of 0.46 per cent, according to the Association of Investment Companies (AIC). It has an FE fundinfo Crown Rating of four.