Two stocks we’ve bought for the recovery phase

Guy Anderson, manager of Mercantile Ord (LSE:MRC) Investment Trust, is the latest participant in our Insider Interview series. He tells interactive investor’s Kyle Caldwell that the backdrop for the area he invests in – UK mid-caps and small-caps – has brightened due to falling interest rates, cooling inflation, and economic indicators improving.

Over the past 12 to 18 months, he’s been adding to a number of companies that plug into the domestic economy and are reliant on consumer spending. He names two new stocks bought in 2024 to play this trend. Anderson also explains how he invests, including how he decides whether to run a winner or take some profits.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today I have with me Guy Anderson, manager of Mercantile Investment Trust. Guy, thanks for coming in today.

Guy Anderson, manager of Mercantile Investment Trust: Thank you for having me.

Kyle Caldwell: To kick off, could you give us a run-through of your investment process and what the investment trust is seeking to achieve?

Guy Anderson: Of course. Mercantile is looking to deliver long-term capital growth for our shareholders by investing in a portfolio of UK-listed mid and small-caps.

The process we use is very much fundamental. It is bottom-up stock selection. We spend a lot of time analysing companies and meeting the management teams. We're looking to get exposure to businesses that have a combination of traits.

Essentially, we're looking to invest in what we think of as structurally really strong businesses with great growth opportunities, where ultimately their current prospects are not reflected in the market's valuation today.

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Kyle Caldwell: The part of the market you invest in, UK mid-caps and small-caps, has been out of favour over the past couple of years as interest rates have risen. However, there's been an upturn in performance of late. Is this all to do with the fact that interest rates are now falling?

Guy Anderson: I think it's definitely one of the factors. If we step back for a moment, mid and small-caps tend to be more cyclical than their larger contemporaries, which are more defensive. A sweeping generalisation. Being more cyclical, they are more exposed to the economy. And in the UK's case of mid and small-caps, they're more exposed to the domestic economy.

So, clearly, when we've been through a period of very significant inflation alongside that great big rate-hiking cycle, that presented a very difficult landscape for mid and small-caps, and so they struggled.

But as you rightly said, where we are now, interest rates have peaked. They're on the decline. Inflation has normalised, and a lot of the economic indicators are improving.

So, I think this definitely presents a better operating landscape for those companies and also a better investment opportunity for us.

Kyle Caldwell: In terms of the opportunities you're seeing at the moment, are there any particular types of companies or sectors that are standing out for you?

Guy Anderson: One of the changes in the portfolio over the past 12 to 18 months is that we have clearly added a number of companies that increase our exposure to that domestic economy and, specifically, in the consumer space.

Two of the largest new investments this year include our investment in Trainline (LSE:TRN), which we made earlier in the year, which is now around 2% of the portfolio. That is a business which sells railway tickets to predominantly consumers in the UK, but also internationally, and a business where we saw a significant acceleration in ticket sales as a result of both railway journeys still recovering post-pandemic, but also increasing e-ticket penetration.

That latter point is really important because I think that's a more sustainable uplift. And their business has, predominantly, a fixed-cost base. So increases in revenue translate very nicely to a significant pick-up in profitability, and that's something we've experienced in the months since making that investment.

Another example is Moonpig Group Ordinary Shares (LSE:MOON). This is the e-card retailer, a company which I guess, in contrast to Trainline, had a fantastic pandemic because we were all stuck at home. Their sales increased, and their customer acquisition increased. But they've had a tough time since the pandemic as consumers have been back out buying physical cards, if you will.

But what we've seen over the last six months is a return back to growth, and we fundamentally like the business. It's a market leader. It's got strong economics, great customer retention, good returns on capital. But the catalyst for the investment earlier this year was really seeing them return to growth. And if they can achieve their targets, which boil down to mid-teens earnings per share (EPS) growth going forwards, that clearly presents a really attractive investment proposition for us in the portfolio. 

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Kyle Caldwell: How often are you making changes to the portfolio? I assume that you're also finding value among your existing holdings as well. Could you talk us through some of the names?

Guy Anderson: I'd love to find a typical year but, on average, turnover in the portfolio is around 20% per annum. So, that would indicate that we're holding our stocks for around five years. So, we are making quite long-term investment decisions.

If I think about what that means in terms of the number of stocks. Today, we've got 80 holdings in the portfolio. On average, we're making 16 new investments per annum. This year, we're running a little bit ahead. I think we've made about 20 new investments, which I think talks to the number of interesting opportunities that we're seeing and the breadth of those opportunities. So, I find that quite a good indicator for the future, actually.

Kyle Caldwell: And in terms of the opportunities that you're seeing in the market at the moment, could you name a couple of examples?

Guy Anderson: Sure. As I said, it's quite that long-term investment approach. So, we do have a number of companies in the portfolio that we really have held for multi-years. Some of the largest holdings, Intermediate Capital Group (LSE:ICG) and 3i Group Ord (LSE:III, are two of the largest positions that we hold. We've held both of those for over 10 years apiece. So, they're fairly mature investments.

We clearly think we know what's going on there, but we keep a very close eye on it. But another big investment in the portfolio, for instance, is a company called Cranswick (LSE:CWK), which is a pork-processing business. That's a company that we've held for a number of years, but the position size does naturally go up and down depending on the relative opportunities that we see. [Cranswick's] one that we increased the size of in the portfolio late last year because we saw that some benefits of the capital they were investing were going to come through this year and beyond.

Kyle Caldwell: And what's your approach when a share that you own is performing well? Do you like to run your winner, or do you take some profits?

Guy Anderson: Absolutely. One of the key tenets or key elements of our investment process is that it's very clearly focused on if an investment is playing out the way we're anticipating, we should run our winners.

But the converse is also true. If something changes with an investment that invalidates our investment hypothesis, the default should always be to recycle the capital. So, it's to try and cut those losers quickly. Of course, we have to differentiate between genuine change and short-term changes or noise, and that's obviously one of the key tasks that we have to tackle every day.

Kyle Caldwell: Mercantile also looks to deliver income as well as capital growth. So, how do you approach that? Do you ensure that there's a certain number of companies in the portfolio that are paying a dividend?

Guy Anderson: I don't look at those sorts of statistics. What we look at instead is, first of all, part of the investment process is very much focused on investing in companies that have strong economics. In other words, [those that] have good margins and good cash flow profiles, and that focus on cash is really important because we tend to find businesses that actually generate a lot of cash can then obviously either reinvest to drive future growth, or can return that cash to us as shareholders.

I think that cash focus is really the key to ensuring that we do get that steady income profile for our end investors. Now, the dividend has grown over the last 30 years at an 8.5% annual growth rate, so clearly well in excess of inflation. And we've seen even over the last 10 years, where we've had a few ups and downs because of Brexit and the pandemic, we've still grown the dividend at about 7% per annum.

One of the things that we keep a very close eye on as we move through the year is the amount of income that we're receiving in the portfolio, so that we never have any surprises. And we split that between underlying dividends and special dividends, so that we really know the true run rate of cash generation. And things have been pretty good on that front over the last couple of years.

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Kyle Caldwell: And how would you assess whether a company, [if] it's trying to grow quickly, if it's a smaller company, [is] over-prioritising paying their dividends rather than reinvesting back into the business?

Guy Anderson: So, a lot of that, I guess, is qualitative through our conversations with management. My team on average, we have between 350 and 400 management meetings per annum with chief executives and chief financial officers of the businesses in which we're investing.

Obviously I don't attend all those, but as a team we have that number. One of the important discussion points in pretty much every single meeting is capital allocation and how the business is looking to drive growth versus return excess cash to shareholders.

And I very much think about it as driving growth and then returning cash to shareholders. So, the priority should be on the growth and we never want a management team to feel capital constraints simply because of a dividend policy.

Kyle Caldwell: Thank you very much for your time.

Guy Anderson: Great, thank you Kyle.

Kyle Caldwell: That's it for the latest episode of our Insider Interview series. Let us know what you think. You can comment, like, and do hit that subscribe button for more videos. I'll see you again next time.