STRATEGY UPDATE

European Equities: Coming in from the shade

Earlier this month, Russell Champion of the RWC European Equity team, took part in an Octo Members debate on the current attractiveness of the asset class in which he invests. The discussion ranged across a variety of topics, including market conditions during the pandemic, the growth vs value debate, ESG and political risk in Europe after Brexit. Read on to find out why he believes the current environment for European equities is as attractive as it ever has been.

Europe is sometimes seen as a representative of the “old economy” whereas the regions of US and Asia are often viewed as more exciting plays on the digitally enabled “new economy”. Do you agree with that assessment?

I don’t completely agree with this notion. The reality is much more nuanced. I’ve been covering the European technology sector for 15 years, having started at Fidelity in 2005. Europe has a lot of tech leaders in areas like financial software and engineering software. These are niche areas where pioneering young companies have either built or are rapidly building very impressive and profitable businesses.

Europe also has a lot of strong, innovative consumer staple brands and medical technology companies. These are our key focus areas, and we are finding plenty of opportunities that more than match the US and Asia for excitement and growth potential. Indeed, we split our portfolios into five categories, two of which are hyper growth and secular growth. Our tech opportunities tend to fall in the hyper growth category, with growth rates often in excess of 20% per annum.

There is, of course, also plenty of value in Europe too, some of which does reflect traditional old economy sectors. So, there are plenty of ways to make money in European mid-caps, and we can flex our exposure to different parts of the market, depending on where we find the most attractive opportunities.

Do you have to be active in Europe?

The RWC European Equity funds consistently have an active share in excess of 90%, so they hardly resemble the broad European equity index at all. We only invest if we have a differentiated view. This naturally leads us towards smaller and mid-sized companies because they are less well-followed and less well-understood than their larger counterparts. This makes it easier to build a different opinion to the consensus, which is what any share price is reflecting.

By way of example, I still view the Dutch technology business, ASML, as a small cap because it had a market cap of less than €10bn when I first invested in it 15 years ago. Its market cap now is more than €120bn. As consensus changes, that’s when you see the opportunity for share price appreciation.

Turning to ESG, do you think Europe is particularly good at any element of environmental, social and corporate governance?

We have always been strong on corporate governance. We meet more than 500 company management teams each year and, over a 30-year investment career, my co-fund manager Graham Clapp has conducted more than 15,000 meetings in total.

More recently, the environmental and social areas of governance have become more prominent on our agenda and our clients are asking about our policies and processes a lot more. 

Our entire investment universe is judged and ranked on ESG factors and, if they fall short, we engage with those companies and make sure they know they are underperforming and ask what they’re doing about it.

I only look at Europe, so I don’t know if it is any better than other regions. But our focus sectors typically rank very well on ESG and the US also has a reasonable exposure to those sectors too, so the differences are probably quite nuanced.

Clearly, the main issues will arise in the more challenged sectors such as tobacco, defence and energy. BP’s recent announcement that it intends to transform its business towards low carbon investment over the next decade, is a great illustration of how industries are rising to the challenge. Hopefully, we’ll be able to score them better on ESG factors in the future.

Why are UK investors reluctant to buy Europe?

Flows towards the European equity asset class have been weak since the Brexit vote in 2016. The perception among UK investors is that there is a risk of political disruption in Europe and the demand has clearly been flowing elsewhere, towards US and global equity funds and fixed interest. This has, of course, gone hand in hand with performance. Market leadership has come from US technology – that is where the excitement is and the money continues to flow towards it, even though valuations are now rather stretched.

There are reasons for optimism, though, aside from the more attractive valuations that can be found in Europe. I believe the risk of political disruption in Europe is overstated. Looking beyond Brexit, the probability that Europe sees a more profound political disintegration is low. It is a tail risk – it could happen, but it is very unlikely.

Meanwhile, if we see more joined-up thinking on fiscal policy, which looks more likely now than ever before, Europe has the potential to prosper coming out of this pandemic. You could argue that the political backdrop is more supportive now than it has been in many years.

Ultimately, the potential for good returns always exists in parts of the market that are under-researched and under-owned. That is Europe through and through.  

Source: Bloomberg, data as at 13 July 2020.

Italy hasn’t grown for years – are you finding attractive opportunities there?

We’ve struggled with the domestic Italian stocks to be honest, because of the over-arching political drivers. I can remember being invested in a domestic Italian bank a few years ago and having to write about it in our newsletter every month because its share price was either up or down a lot on political issues. I would rather focus on the things I can predict.

There are always opportunities to find global champions that just happen to be domiciled in Italy, however. Companies like Gucci, Prada and Ferrari are global leaders in their fields and have represented good investments at different times.

We own Prada at the moment, and we’ve also recently invested in a company called Brembo, which makes braking systems for the automotive industry. We’ve been a bit early on the auto recovery, but car sales are picking up nicely in China and, if the same happens in the US and Europe, there is plenty of recovery potential here.

How have your companies fared during the pandemic? Have you seen any winners?

The funds we manage have been well ahead of the benchmark this year, with a positive contribution coming from the hyper growth stocks I mentioned earlier. For example, the German food delivery business, HelloFresh, was our largest position for much of the year.  For a while, the consensus was debating whether it would ever be able to turn a profit, due to its relatively high marketing spend and high levels of customer churn. This meant that analysts were missing its ability to gain scale in purchasing and logistics. During the lockdown, new customers were willing to go give HelloFresh a go and, unlike many other food delivery businesses, it was able to fulfil this surge in demand.

Meanwhile, Danish medtech business, Ambu also performed well because demand for its single-use endoscopy products increased significantly as the crisis shone a light on the infection risk of re-usable endoscopes. We’ve also been invested in TeamViewer, which offers remote desktop support software since its IPO last year. These are all positions that we made bigger quite early on in the crisis because we realised they would see additional demand drivers. They already had structural trends in their favour, which have been reinforced by the crisis.

On the flipside, anything which is linked to the energy sector has struggled, as have many consumer-facing companies that have not been able to open stores. Broadly speaking, the market consensus is now looking through this year and looking towards normalising profits in 2021 and 2022, so we’ve seen a good recovery in many stocks.

There are always winners and losers, even in these difficult times.

Turning to the value vs growth debate, have you seen any signs that value may be coming back into fashion?

Some of the traditional “value” industries, such as banks, energy and telecoms, sit outside of our core focus sectors. We would never start an investment thesis with something that hinges on macroeconomics or regulation.

Our approach is style agnostic. I spoke earlier about our hyper growth and secular growth categories. Our other three categories tend to be more value-oriented – these are recovery, cyclical potential and special situations.

Recovery stocks often have value characteristics. Something has gone wrong at a company, which means that more growth-focused investors stop looking at it. Pandora is a recent successful purchase for the funds. It was on a growth path, but it lost its way while trying to diversify into general jewellery. It lost its shine and became viewed as a value stock. Now, new management has come in and is getting the recovery back on track.

Hastings, meanwhile, was also added recently due to its cyclical potential. We saw signs that the insurance cycle was bottoming out, alongside a potential pandemic benefit from reduced driver hours. The company has subsequently been bid for, which has very quickly realised the undervaluation that we saw.

So, we are starting to see some performance in recovery and value. For us it doesn’t matter which one is popular though. We are confident we’ll find opportunities across the market, regardless of what style happens to be in fashion at the time.  

Source: Bloomberg, data as at 9 June 2020.

Is there any sign of an increased appetite for M&A?

There’s always an appetite for deals. When I started at Fidelity, working with Anthony Bolton and Graham Clapp, there was always a mid-cap focus, and there will always be more M&A activity here than in large caps.

In times of crisis, M&A does tend to suffer. As things normalise, however, and as confidence returns, there’s a lot of private equity cash sitting on the sidelines and corporate balance sheets are not particularly stretched. So, I would expect to see activity pick up.  

How are you factoring a potential second wave of coronavirus infection into your thinking?

We talk to two or three company management teams every day, so we’re hearing how the environment is evolving in real time. We then factor this into the scenario analysis that we conduct for all investment opportunities. When looking at a negative scenario for a particular stock, for example, we will factor in the prospect of a second wave and the potential reintroduction of lockdowns. These things need to be considered, particularly if we’re looking at something like a hotel group or an airline.

Clearly, we’ve seen massive downgrades this year for most stocks but, since bottoming in March, the market has started to look through this year’s depressed earnings and is focusing on future years. Now, it’s the long-term impact on a business that needs to be considered. For example, what will demand for a gym group look like and what sort of business model will suit that demand. This is the sort of thing we’re thinking about – we are trying to ascertain what has become more attractive and what has become less attractive.

This is difficult analysis at any time, but this pandemic makes it particularly tricky because it is unprecedented. We have the context of 30 years of meeting notes to draw upon, across all sorts of economic and market conditions. But this environment is new to everyone. Government policy, the European Recovery Fund, changing consumer behaviour – these are all important things to think about for the future.

How excited are you about prospects for Europe from here?

Equity markets have been increasingly narrow over the last five years and if you’ve invested successfully, chances are you’ve had decent exposure to US technology and quality growth. Looking at valuations now, they have moved significantly and there is a risk that we’re much closer to the top than the bottom.

Why am I excited enough to put more of my own money into Europe right now? Well, post-Brexit, Europe can have a much clearer path forward and deliver better growth. We are not macro investors – we just see lots of opportunities in businesses that are not well followed, but that can beat low expectations.

The environment is as attractive as it ever has been.

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