European equities: Oui ou non?

William Heathcoat Amory – Oui!

 
My cousin is a long-running Eurosceptic (you can buy his book, which was published ten years ago, here). I’m not going to risk not getting a Christmas present from him this year by debating whether his observations on Europe are accurate, but from an investment perspective there is much to like about the Continent, or at least within it.

That’s because despite the complexity of having 27 countries that make up the economic and political union that is the EU, the story from an investment perspective is fundamentally company-specific, and from a fund or investment trust perspective is centred on the ability of managers to add considerable alpha by sorting the wheat from the chaff.

Rather than focussing on what Europe doesn’t have, it’s worth considering what it does have. Within the ranks of companies listed in Europe, there are many of global significance that dominate their respective markets on a world scale.

Loosely, Europe represents a huge consumer market, with a pool of skilled and educated workers balanced with a large developing market within the union. Admittedly, the EU is highly regulated and has higher taxes than other places in the world, but its stability and size are attractions for long-term investors and corporates.

For example, Europe has been well ahead of other continents in acknowledging the need to tackle climate change and finding solutions to address it, a strategy which the present Ukrainian situation only supports. The faster that European countries can develop low-cost renewable energy sources, the more sustainable (with a small ‘s’) their competitive advantage over other regions will be.

Similarly, the brands, intellectual property and quality of product that European companies possess are second to none, presenting a significant competitive moat for US and/or emerging market competitors.

Over the long term, there are therefore plenty of tailwinds which should ensure that European champions can remain champions on a global scale. Over the short term there are definitely tricky times ahead, but which country or continent doesn’t face these at present?

Entering from a position of relative weakness in terms of valuations, expectations and currency valuations is not a bad place to start. Politically, there is nothing like a common enemy to bring friends together, and Russia’s presence as such a clear and unequivocal aggressor might cause the bickering between sibling nations to end and a solidarity between brother nations to begin.

Certainly, recession is looming, which may be exacerbated by a cold winter forcing energy rationing. However, according to research from Gavekal, the picture may not be as gloomy as one might be led to believe.

According to data from Reuters, the EU’s gas storage facilities are 88.3% full as at 28/09/2022, thus exceeding the minimum target of 85% needed for the beginning of winter. To Gavekal, this suggests that EU countries will have to reduce gas consumption by no more than 2% relative to average winter consumption levels between 2017 and 2021 to ensure adequate supplies through to next spring, with no need for enforced rationing.

That said, aggregated figures for the EU as a whole do not reflect the situation in individual economies. Gavekal believes that for Germany, historically one of the countries most dependent on Russian gas and an engine of the European economy, the worst-case scenario will not be as dire as previously feared. Germany’s gas reserves were 91% full as at 28/09/2022, and Gavekal suggests that German gas consumers will have to reduce the amount of gas they burn by between 11% and 16% relative to a normal year if they are to avoid enforced rationing, a much lower reduction than previous forecasts of reductions of between 16% and 26% being needed.

Gavekal believes that enforced gas rationing in Germany this winter may depend on the weather, and that unless Germany suffers a colder-than-average winter, its gas reserves will be high enough to avoid enforced energy rationing. This is very different to what many doomsters are saying, but is clearly predicated on a relatively mild winter.

There are plenty of risks to the upside that, when combined with the wide discounts exhibited by the European investment trust peer group, could prove useful in UK investors’ portfolios, which are likely dominated by UK stocks and US mega caps. The European trust sector has traded at a consistently wide discount over the past few years, but discounts are now very wide by historical standards.

The average Z-score (the number of standard deviations from the one-year average) across the sector is -1.2 to value. NAVs are down by an average of 23.6% year to date (29/09/2022), and so European trusts are underperforming their various benchmarks by quite some margin – a function we believe of the higher growth bias in trust portfolios.

In contrast, an outperformer relative to the peer group year to date has been Henderson European Focus Trust (HEFT), which employs a strategy with a strong valuation discipline. Under the leadership of its managers Tom O’Hara and John Bennett, HEFT follows a long-term, bottom-up approach to large- and mid-cap equity investing with a process characterised by style agnosticism.

The managers ignore shorter-term fluctuations in investor opinions and style tailwinds, and instead account for fundamental strength, be that in strong balance sheets or cash and revenue outcomes. The team’s ability to foresee positive changes to companies, even in unloved sectors, has been a constant feature of HEFT, and has led the team to avoid the highly valued end of the European market which has suffered most over the last 12 months.

And while the duo would never claim to be prophetic, they have long called out the exuberant valuations of many European equities, as well as believing that the market was taking a naïve, broad-brush approach to ESG, a notion which has since come home to roost thanks to the outbreak of the Ukrainian conflict.

BlackRock Greater Europe (BRGE), on the other hand, is relatively growthy. The share price has been knocked, with an NAV fall of 35.7% year to date exacerbated by the premium rating giving way to a discount, and leaving the trust’s shares trading at a 6% discount to NAV. BRGE’s investment universe includes developing Europe, and it has a quintessential stock-picker strategy, with manager Stefan Gries preferring to focus on corporate fundamentals rather than macro factors, thus allowing investors to benefit from specific companies’ performance rather than broad economic trends.

Two trusts are trading at very wide discounts in absolute terms, and both have highly idiosyncratic managers who employ a clear investment process and focus on the long-term prospects for companies. Henderson EuroTrust (HNE) is amongst the most sustainable trusts in the AIC Europe sector.

Jamie Ross, manager since February 2019, invests in Europe’s highest-quality growth opportunities. He has been adjusting the portfolio to raise its overall quality, arguing that with rising input prices, only high-quality businesses will be placed to absorb these costs and pass on price rises to consumers.

European Opportunities Trust (EOT) owns a portfolio of companies selected by long-term manager Alexander Darwall because of their ‘special’ qualities. In Alexander’s view, these companies are differentiated and have unique products which make them likely to be leaders not just in Europe, but also globally.

Alexander manages the trust in a high-conviction manner with a concentrated portfolio, but EOT is also differentiated because the mandate allows him to invest in the UK. There are worries on the horizon for equity investors, but Alexander has always invested in companies that in his view should be able to deliver good long-term returns, irrespective of the economic environment.