fleming mercaNTILE TRUST FAVOURS DIVERSIFIED APPROACH WHILE WAITING FOR DIRECTIONAL CLUES
The £795.2m Fleming Mercantile trust is sitting on a broadly diversified portfolio while waiting for the market to offer some directional cues.
The trust invests in UK stocks outside the FTSE 100 index, with a bias towards mid-caps.
Martin Hudson, who runs the fund with co-manager Katy Woodhouse, said while mid and small caps appear to be offering good value, buyers are still holding back. 'On an arithmetic basis, the stock market is good value,' he said. 'We are on prospective yields in our part of the market of 5%. That's a growing dividend yield and is covered by more than two times.
'If you compare that with inflation or bonds, it suggests this is a sensible level. But that doesn't mean the market is going up or down.'
Hudson believes the lack of marginal buyers is keeping equity valuations on the back foot.
'The insurance companies are still going into bonds, pension funds are overweight and the asset class is not interested in taking a gamble,' he said.
The managers are keeping Mercantile spread across most market sectors, with only modest overweights in housebuilders and real estate.
'Housebuilding still looks dynamic because people aspire to having a better house and there is a structural undersupply of housing in the UK,' Hudson said.
However, building stocks are still on very low valuations, according to Flemings, with P/Es of around five times, yields of 4% and market caps around or equal to asset value. Hudson believes fears of another post-boom collapse in housing as seen in the late 1980s is misplaced.
'Last time, they were all heavily geared and involved in large speculative developments and ended up having to write off enormous property investments,' he said.
'It is still mainly the same management running those companies and they have learnt their lesson. The companies are no longer as highly geared or involved in excessive speculation but the valuations haven't caught up with that. They are generating asset value.'
Mercantile is also underweight engineering companies as the outlook for business capital spending remains downbeat.
'If themes emerge, we are in a position to play that but in the absence of themes, we try to pick up some relative performance through stock selection, and there is still scope to do that,' Hudson said.
On 11 March, the trust was trading at a discount to NAV of 8.1%, compared to a UK Mid Cap sector weighted average of 9.1%.
The trust is holding 175 stocks, below its usual count of around 200. Half the holdings are mid-cap stocks and half are small caps, although by value the trust is invested 85% in the FTSE 250.
Unlike many specialist smaller cap funds, Mercantile can invest in companies capitalised at less than £50m, finding targets even in stocks of £10m-£20m.
'We like to find opportunities to buy very small companies that are going to grow and move forward over the next five years,' Hudson said. 'If you get it right, they can move right up into the mid-caps and even the FTSE 100.'
The trust has gearing of around 10%, which has been a drag on performance during 2002 but is set to remain in place in preparation for an expected upturn.
'We don't have much confidence in our ability to predict the exact turning points in markets,' Hudson said. 'We rule out the risk of getting it wrong by holding the gearing at 10%, which is below our normal 15% and therefore reflects some caution. But when growth begins to come through, it will really help.'
In the meantime, the cost of the gearing, which carries interest charges of 6.125%, continues to hold back performance. 'Last year, we were about 3% on stock selection but gave back 3% on cost of gearing,' Hudson said.
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