The Mercantile Investment Trust: Budget outlook and portfolio managers’ views

Guy Anderson, co-manager of The Mercantile Investment Trust (MRC), is the first to acknowledge that for investors like him, with a focus on medium and smaller UK businesses, the past year or so has provided some welcome respite after a torrid few years, as inflation finally eased materially and the Bank of England made its first base rate cut of the cycle.

Until recently the domestic outlook was strengthening, with low unemployment and real wage growth since June 2023 – and that has provided a healthy boost to consumer confidence and consumption.

The Mercantile’s bias to quality growth UK companies at attractive valuations left it well placed to capitalise on this improvement in sentiment, and the shares have rewarded investors with an impressive run.

But for the past few months the new Government’s first Budget had been casting a long shadow over prospects for business generally, particularly given chancellor Rachel Reeves’ concerns over an alleged multi-billion shortfall in the Treasury coffers and the manifesto promises not to tax working people’s pay.

Reeves chose to target employers’ National Insurance (NI) as the centerpiece of her revenue-raising exercise, raising £25 billion over the life of this parliament. The measures she announced not only hike employers’ NI by 1.2% to 15% from April 2025, but also slash the annual earnings threshold at which those contributions have to be paid, from £9,100 to just £5,000.

The combination of the employers’ NI rises and increases in the National Living Wage amounts to a challenge for The Mercantile managers as bottom-up UK stock-pickers, says co-manager Anthony Lynch. However, this is where the team’s expertise comes into its own.

“This is one of the most material uplifts we’ve seen,” Lynch comments. “Where businesses have a high level of low-paid workers – in hospitality or retail, for example – mandatory wage increases have already meant that we have had to be really selective for a number of years, and now we have employers’ NI rises as well.” For The Mercantile, it comes down to looking for businesses with the pricing power to pass those rises through to prices without impacting trading volumes.

He points to the big supermarkets as a sector that has done a particularly fine job of managing labour inflation. “In the past two years, the payroll wage bill for our holding Tesco has risen by £800 million - a third of its profits. Yet it has been able to pass that through to consumers while improving its price competitiveness relative to rivals and also maintaining margins.”

Rising wage bills can also open opportunities for business to make savings by becoming more efficient and capitalising on technology. Another Mercantile holding, security and cleaning business Mitie, has introduced robotic cleaners, while flexible labour rostering has helped it improve workforce retention.

Similarly, the centralised intelligence centre for Mitie’s security arm has brought further efficiencies. ”All of these elements are helping Mitie establish a technology-driven moat in a labour-intensive industry, in a way that peers just can’t compete with,” argues Lynch.

Some macroeconomic fallout is expected from these tax changes. Although the Bank of England reduced the base rate by a further quarter percentage point in October, there is recognition that rising labour costs will push through to consumer inflation to some extent and may delay further interest rate reductions in coming months.

Elevated rates are a headwind for many businesses, but inevitably there are also beneficiaries. “It’s pretty constructive for our already positive view on banks, because ‘higher for longer’ rates are very supportive of net interest income,” explains Lynch.

Effectively, banks in the UK will earn more than people expected for longer than they expected – and against that backdrop, he says, “banks look far too cheap”.

Other sectors are set to benefit from positive measures for growth announced in the Budget. Importantly, the Government’s pro-growth agenda provides open support for housebuilders – “a stark contrast with the last couple of years” – while the focus on public sector investment will stimulate the wider construction industry.

This is particularly good news, Lynch believes, because “new homes construction is a near slam dunk when it comes to the multiplier effect for economic growth”. Again, though, stock selectivity is crucial. The Mercantile favours housebuilder Bellway as the cheapest good-quality name in the sector. “It’s trading below book value, yet set to grow its volumes faster than anyone else in the sector over the next two years,” Lynch explains.

He is also positive about prospects for school builder Morgan Sindall as a route into public sector construction, and for builders’ merchant Grafton. The latter’s Irish business is already booming in the country’s low-tax environment, and potential UK recovery further boosts the outlook. “I think Grafton is a business that could do very, very well,” he says. “There’s a lot of cash on the balance sheet and the valuation is outstandingly cheap.”

Overall, there’s a sense among The Mercantile’s managers that although the Budget will bring pain for many businesses, there are real opportunities to fortify the portfolio further by sniffing out the companies with the best growth prospects and the most attractive valuations.

Moreover, with improving economic fundamentals and greater clarity as to where the hits will be felt, the expectation is that the quality companies in which The Mercantile invests will have the strength to manage those downsides and move on to greater things.