A tale of two quarters
After suffering a tumultuous fourth quarter last year, European equities rebounded in the first three months of the year as investors shrugged off Brexit-related uncertainties and softening economic data in the region.
In Q4, against a backdrop of increased volatility, many investors rotated towards ‘unloved’, low-growth companies, forgoing those that demonstrated high-growth potential.
But everything changed in the first three months of this year. US-China trade tensions eased (albeit temporarily), the US Federal Reserve (Fed) abandoned projections for further rate hikes this year, Chinese Premier Li Keqiang vowed to stick to the targeted economic support strategy and the European Central Bank (ECB) reassured investors that rates would “remain at their present levels at least through the first half of 2020.” As a result, European equity markets rebounded.
But volatility soon returned amid a re-escalation of the US-China trade dispute in May, which dominated the headlines for much of Q2.
Markets resumed their ascent following the dovish turn of the Fed and ECB at their monetary-policy meetings in June. Indeed, the move largely reflected the ongoing trade dispute between the US and China: at the time, ECB President Mario Draghi noted “downside risks to growth and inflation have now materialised”. In turn, risk appetite waned as markets fell and investors rotated to more defensive areas of the market.
As we reached the middle of the year, trade tensions between the US and China eased following a meeting between the countries’ leaders at the G20 summit in Japan. This provided further impetus for European equity markets.
Mid-way mark: strong performance in a challenging market
Against this backdrop, the Hermes Europe ex-UK fund enjoyed a strong performance in the first six months of the year. The F GBP Accumulating share class returned 20.37% net, outperforming the benchmark index by 246bps.
Figure 1: Europe ex-UK enjoyed a robust H1
Source: Hermes, Bloomberg, as at August 2019. Figures shown is the relative return of the Hermes Europe ex UK F accumulating GBP share class since December 2014, when Tim Crockford’s tenure as lead portfolio manager began. The growth compared to value shows the S&P Europe Large Cap Growth Total Return Index divided by the S&P Enhanced Value Europe Large Mid Cap Total Return Index. Past performance is not a reliable guide to future performance.
Stock selection was the key driver of this outperformance. That is because we take a bottom-up approach to investing, seeking to identify companies or industries that are undergoing longer-term structural change through our own independent research, around a framework of themes that help us identify disruption and change.
In the first half of the year, our outperformance was primarily driven by stock selection in the oil and gas, technology and utilities sectors as well as our overweight position in industrials and underweight position in financials. Conversely, stock selection in the basic-materials sector as well as our overweight position in oil and gas and underweight in consumer goods were the biggest detractors from the fund in H1.
At company level, the largest contributors to our outperformance included:
- Satorius: the biopharma group reported forecast-beating Q1 results, driven by higher-than-expected margins in its bio-process and lab-products divisions;
- Adidas: the sports clothing company enjoyed above-consensus earnings reflecting an increase in its gross margin and strong sales in Russia and Asia Pacific; and
- ASM International: earnings also beat expectations with strong orders in foundry and logic that led to the company raising guidance for its Q2 sales.
Meanwhile, the biggest detractors were:
- Umicore: the materials company released disappointing guidance for 2019 after there was lower-than-expected demand for cathode materials in China and South Korea;
- Bankinter: the Spanish bank struggled on fears that lower-for-longer rates could continue to squeeze net interest margins; and
- Ubisoft: the video-game firm reported disappointing sales of its ‘The Division 2’ game, while guidance for 2019 to 2020 was below expectations.
Figure 2: Europe ex-UK net returns since 2015
Source: Hermes, as at August 2019. Tim Crockford’s tenure as lead manager commenced on 1 January 2015. Performance shown is F GBP Acc Share Class. Relative returns calculated arithmetically. Returns in excess of one year are annualised.
Figure 2. Europe ex-UK fund: rolling performance (net)
|30/06/2018 to 30/06/2019
||30/06/2017 to 30/06/2018
||30/06/2016 to 30/06/2017
||30/06/2015 to 30/06/2016
||30/06/2014 to 30/06/2015
Source: Hermes, as at August 2019. UK F accumulating GBP share class. Performance shown is in GBP, net of fees. Past performance is not a reliable guide to future performance.
We take a long-term, high conviction approach to investing with a focus on unrecognised and enduring change. This approach ensures that stocks are only bought when we have clear insights into factors that will generate positive change in the business and which will persist over time. For that reason, portfolio activity tends to be low.
Earlier this year, we added Norwegian-listed recycling company Tomra to our portfolio. In 1972, Tomra created the first fully-automated reverse vending machine (RVM) – a machine where people can return empty drink containers, such as plastic bottles or aluminium cans, for recycling. Today, Tomra is the leading global provider of RVMs, with more than 82,000 installed across more than 60 markets.
Figure 3: What happens when a used drinks container is recycled?
Source: Tomra, as at August 2019.
We look for companies that are exposed to structural growth themes not yet reflected in street forecasts, which we believe will eventually lead to higher future cash returns. Tomra is one of these firms.
According to the World Bank, the world’s mounting waste pile is set to grow by 70% from its current levels to 2050. Plastic represents 12% of all solid waste, but only 14% of that is recycled. The topic burst into the public consciousness when the BBC documentary ‘Blue Planet II’ aired, piquing interest in plastics recycling. We think that Tomra should benefit from growing regulatory pressure to tackle the plastics problem.
Tomra’s sorting-solutions division also looks set to benefit from this trend as demand for recycling infrastructure increases. At present, recycling infrastructure in many countries is inadequate. For example, the EU has set a target for all plastic packaging to be recyclable or reusable by 2030 – this will require a four-fold increase in recycling capacity.
We believe that Tomra’s market-leading position and its technological advantage provide a springboard for growth that is not reliant on a particular macro environment. We have met the company numerous times over the past 12 months and are convinced that its growth will accelerate as Western countries invest in recycling solutions.
Positioning for success
The fund’s overall positioning has remained broadly consistent over the past six months. The largest overweight positions are still in industrials, technology and oil and gas, while we have maintained our underweight stance in consumer goods, financials and consumer services.
Approximately 75% of the fund’s holdings have a thematic tilt and all its positions are held with conviction. This approach results in a portfolio with notably different stock weightings to those of the benchmark, creating a high active share.
Although the portfolio contains only 30-60 stocks at any one time, we do not rely on a handful of ‘best ideas’ and the fund has a relatively flat active-weight structure. This helps ensure the portfolio remains reasonably well diversified at the stock level, despite its high conviction, concentrated investment approach.
Beware short-term thinking
The potent cocktail of synchronised monetary easing and ongoing trade tensions mean that the valuation gap between quality growth and cyclical value companies continues to expand. The last time quality growth materially underperformed value was late 2016, in the context of synchronised global growth, rising inflation and tightening interest rates. All three factors are conspicuously absent today.
Our focus will now be on second-quarter earnings where we expect aggregate downgrades. This is unlikely to alter the style dichotomy, however. While poor earnings will elicit a market reaction, we are also aware that bourses generally value companies in a short-term and linear fashion. We will look beyond the noise and continue to search for firms that can deliver long-term growth to their shareholders.
Sceptics continue to write off Europe: there is an almost constant flow of investor funds away from the region. Despite European markets returning over 17% this year in euro terms, individual stocks and sectors remain volatile. Indeed, some areas – particularly the more cyclical ones – are very far from being expensive on anything greater than a one-year horizon. As we’ve said before, the time to worry is when investors are euphoric. That still looks a long way off in Europe.