Good reasons to view the outlook with confidence

The Mercantile invests in high quality, resilient UK businesses capable of withstanding near-term uncertainties and set to benefit from structural growth over time. The Company focuses on mid and small cap stocks, as these businesses typically grow faster and generate higher long-term returns than larger, less innovative companies, and thus possess the greatest capacity to transform into future market leaders.

Like most equity investors with a quality and growth bias, The Mercantile’s performance has suffered during recent market volatility, and the short-term economic outlook undoubtedly remains challenging. Consumer demand will weaken as discretionary income is eroded by mortgage rate and cost of living increases, and companies are likely to curtail investment plans until they have more clarity on the economic and geo-political outlook.

To strengthen the Company’s capacity to withstand these near-term difficulties, The Mercantile’s manager has made some significant portfolio changes. Most notably, he has reduced its overweight to consumer discretionary, as he expects this sector will be worst hit by rising rates and prices. Some of the proceeds of this portfolio adjustment have been used to increase exposure to energy. The Company had limited exposure to this sector since the beginning of the pandemic, but in late 2021 the manager opened a position in Serica Energy, a North Sea gas producer. Since then, the war in Ukraine has increased demand for oil and gas and the manager has added a position in another producer, Harbour Energy, and acquired or topped up positions in companies such as Hunting, IMI and Rotork, which provide equipment and services to the energy sector. Defence holdings have also increased, with a long-standing investment in QinetiQ supplemented by a new position in Chemring.

What is the Mercantile Investment Trust outlook for 2023?

With these changes in place, The Mercantile’s manager is cautiously optimistic about the outlook for 2023 and beyond, for several reasons. Firstly, the portfolio is well-positioned to withstand any further near-term negativity, and to benefit from recent developments such as rising energy prices and escalating defence spending. Second, he expects inflationary pressures to ease next year, as pandemic-related supply chain constraints dissipate, labour market conditions normalise and the squeeze on consumer spending eases retail price pressures. This may allow central banks to signal an end to aggressive policy tightening, which should support the valuations of the quality and growth stocks the manager favours.

Third, with so much gloomy news now priced into equity markets, the valuations of many interesting companies are, arguably, looking particularly compelling, offering an appealing entry point for long-term investors. The UK market also remains attractively priced relative to its counterparts in other industrialised economies. In addition, FTSE 250 companies have, for some time, been subject to M&A activity, and foreign investors may be further tempted by the current historically low level of sterling. These valuation factors should underpin the market over time. And as and when economic and market conditions begin to improve, The Mercantile’s manager has significant gearing capacity at his disposal to enhance returns by leveraging into a rising market.

In the meantime, the Company continues to offer shareholders a competitive, and rising, dividend - a particularly important consideration given recent cost of living increases. The Mercantile’s Board aims to deliver dividend growth in line with inflation over the long term. It has never cut the dividend, even during the pandemic, when many portfolio holdings were forced to suspend dividend payments. Instead, the Board drew modestly on the Company’s ample reserves to supplement its dividend payouts. While the outlook for 2023 dividends is somewhat uncertain, it is reasonable to expect that, if necessary, the Board will once again draw on reserves to maintain the Company’s dividend track record.

Conclusion

In sum, there are good reasons to share The Mercantile manager’s cautious optimism about the future. And investors may draw further confidence from his track record of long-term outperformance, which attests to his skills in identifying great, innovative companies capable of delivering attractive returns - and leading the way to better times ahead.

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