Perhaps one of the striking aspects of investing in European equities five years after the introduction of the euro, is the continued ambiguity of what a European mandate should represent. It is rather as if when considering an American mandate, the choice included mandates for the US excluding Texas as well as broader mandates with Chile, Brazil and Argentina included alongside the US and Canada in one portfolio.
Whilst such mandates are clearly ludicrous in a US context, this is not so in the European marketplace, where historical precedents combined with the growth of the Euro-zone has left the marketplace somewhat bewildered. Besides the common Europe ex-UK mandates for UK based institutions, SGAM for example, also have Europe ex-France alongside their Euro-zone and Pan-European mandates.
The universe that managers can consider varies from the largest 300 stocks in the developed European markets that Fortis Investments for example concentrates on, to Pictet’s approach where according to Ann Steele, head of the European equity team, they cover everything from “Iceland to Turkey and from Ireland to Russia”.
Clearly, the first step in considering investing in a European mandate is to decide what it is meant to represent and perhaps most importantly, are fund managers able to really exploit their skills in the mandate as given. This is particularly relevant when it comes to deciding whether and how much of the emerging economies of Europe should be included in any European mandate rather than in an Emerging Markets mandate.
As Pictet’s Stephen Barber points out, “it might appear to make sense to exclude emerging European markets from a European mandate, if it is accepted that added value comes more from country bets than stock-specific bets. But that means that firms such as Pictet, with bottom-up stock selection skills across the wider European space, are not being employed to their best advantage”.
In a world of generally single digit returns forecast for developed equity markets as a whole, managers are relatively optimistic about European equities. Stuart Owen at BGI for example, says of the European equity markets “The economic environment is awful, it always has been. But on market selection models, valuations look attractive and the flow of funds argument is attractive”. However as Marie-Pierre Sapin-Knox of SG Asset Management declares: “Returns are not going to be the crazy years of double digits. In 2004 MSCI Europe did 12%, a good return. We may have lower returns of 7-8% in 2005, which is the long-term average”.
Emmy Labovitch at Fortis Investments says that they are also “relatively downbeat on returns. We see single digit returns over the next few years and no reason at this stage to expect a big rally looking further ahead. We are worried about topline growth, where is it going to come from, especially with the falling dollar? Encouragingly, M & A has been strong at the end of the year and the oil price is heading downwards. Now we are looking for companies and sectors that give shelter from the US dollar”.
As she points out, “companies have been announcing lots of share buy-backs and dividends as they have cut investment and there is cash to spare”. To aim for higher returns means taking on more risk. Pictet hope to get higher returns according to Ann Steel, “from bottom-up stock picking across the wider European universe – we can have up to 25% invested in Emerging Europe in our mutual fund”.

Fund management approaches
Active Quantitative: Managers who use quantitative approaches tend to use the same techniques, albeit with local variations, for all the developed markets. BGI’s European active quantitative process for example, according to Stuart Owen, is based
on a global approach with a team of
10 in the UK, out of around 100 research staff globally, covering UK and continental European stock selection mandates.
They look for systematic market inefficiencies based on four clusters of variables:
q Changing expectations such as earnings revisions and other forecast revisions, which give a measure of momentum;
q Valuation metrics, for example, the rate of return a company makes above or below required rates as well as break-up values and private equity approaches which use option maths to see how much debt a company can bear;
q A quantified systematic measure of earnings quality and sustainability;
q A variety of other factors which varies by country, such as directors share trading, level of short interest, etc.
The level of short interest is interesting because theoretically shorting is risky and expensive so there should be a premium for the risk of shorting according to Owen. For European mandates, clients have the flexibility to add country and currency selection views, based on similar quantitative signals, via an overlay approach that uses futures and forwards.
They would typically have around half the number of stocks in the index in their portfolios. The exact number would vary as the approach focuses on building a portfolio to a risk target and if the dispersion of stock returns goes up then you need more stocks. One advantage of quantitative approaches is that they are generally straightforward to run on a short basis to produce long/short hedge funds and BGI have taken advantage of this
with $600m(E456m) in European long/short hedge funds.

Sectors: Adopting a sector approach on a European scale is an obvious approach that many managers have followed. Fortis Investments for example, according to Emmy Labovitch, cover the top 300 stocks out of the MSCI Europe index on this basis for both retail and institutional clients. Most clients have Pan-European mandates but they also have Euro mandates with the same process.
Fortis have a team of 13 analysts in addition to four fund managers. The analysts pay attention to the “catalysts” of change, which would move stocks sharply from or towards their fair value or which would signal a change in direction for a sector as a whole. These include economic indicators, comparisons with the US market for that sector and the shape of the yield curve.
Company visits are seen to be a very important contribution, and as Labovitch explains: “Many of the visits are done in conjunction with credit analysts who sit close by and have a different and complementary view of a company’s health”. The output of the analysts consists of a ranking of the universe of stocks they cover plus detailed discounted cashflow models for stocks and sectors which are passed on to the fund managers.
Portfolios are run on three bases: benchmark portfolios, which aim for a 4% tracking error against the MSCI index and outperformance target of 2%. Turnover target for this strategy is around 10%; secondly, a “best selection” of 30-40 stocks run on an absolute basis, with no benchmark; finally, they also have two hedge funds with €120m under management.
Stockpicking: For many fund managers, it is bottom-up stock picking that is the key driver. SG Asset Management, sees it as contributing to 80% of the added value, with the remaining 20% from sector and country allocations. “When an opinion of a company is negative, it is excluded from the purchase list” according to Marie-Pierre Sapin-Knox, in contrast to underweighting it as would the case in a classic benchmarked arrangement.
Management of institutional mandates is undertaken from London although they rely to a large extent on the output from the Paris based Europe Equities Research Department. The latter look at 300 stocks which represent 90% or more of the European stock market capitalisation with London concentrating on around 150 stocks less intensely monitored in Paris.
The key criteria that SGAM look for are both qualitative and quantitative. From the qualitative point of view, companies need to “have a strong position and are progressing in their business field; benefit from an acknowledged management which has a good strategic vision of their business; have reliable and transparent accounting procedures; are able to generate cash flows in all phases of the economic cycle; control the prices of their products or have sales growth higher than that of the market”. Whilst the key quantitative criteria are those companies “whose share price appears to be clearly undervalued compared to their potential and which have solid financial ratios like ROE, P/B, cash flow multiples, etc. The ratios used vary in terms of the sectors studied.”
Pictet sees its competitive edge, according to Ann Steele, as adding its long-term expertise in Emerging Europe and European small cap with its existing franchise in core European equities.
“As a stock picker, it is fantastic as there are lots of convergence plays in emerging Europe. For example, we have a German company, which used to be a tyre company, which closed its factory and moved east, and now does added value products from there. Other companies in emerging Europe can sell goods to the west and have access to cheap labour.”
As Steele puts it: “We are bottom up stock pickers – which reflects our background as analysts. We cover the full range of small, medium and large cap and are definitely not benchmark huggers”.
Pictet has three fund managers in London and 23 analysts in Geneva and eight sector heads. The sector heads take all the analysts’ ideas and rank them. Valuations are the critical factor and they “use different screens to select companies on different valuations”.
Company visits also play an important part. “It’s not what they say but how they answer our questions in one-to-one meetings. We own a lot of mid-cap companies and after you have seen them a number of times, if something goes wrong in the share price, you can ring them and learn more and whether it is worth keeping the stock”.
The number of stocks in a portfolio according to Steele, would typically be 60-80 and she hopes to have a turnover of around 40% going forward. “If we do have closer to 80-90 stocks, it would be because we would be having more small cap stocks. We have a lot of stocks not in the index”.
JP Morgan Fleming Asset Management has two distinct European equity capabilities, which it refers to as a ‘behavourial finance’ approach and an ‘analyst-based portfolio’ approach. Steven Macklow-Smith describes the behavourial finance approach of his team as predicated on the idea that markets are extremely efficient so extra-ordinary returns can only be seen through focussing on the extremes of value and price momentum.
This is an idea that other firms such as GMO have based their completely quantitative approaches on whereas in contrast, Maclow-Smith sees the quantitative screens as just the first stage before undertaking fundamental analysis. Their portfolios are segmented into the two classes of extreme value and momentum sub-portfolios.
Value stocks that have been screened on P/E ratios are validated by other measures such as dividend yield, price to sales and price to cashflow. The quality of the company is assessed by looking at the trends in analysts’ estimates whilst a key criterion is seen as identifying the catalysts that will trigger outperformance. Price momentum is based on periods of six-months to a year and their analysts seek to understand why consensus estimates are moving in the direction they are - the view being that sell-side analysts tend to gradually reflect optimistic views over a period of months. Such a bottom-up stock selection approach means that they do not have strong sector or country views and would rather stick close to the index weightings.
JPMFAM’s analyst-based portfolio approach is, as one can guess, a more conventional approach based on teams of sector analysts focussing mainly on the large cap stocks. JPMFAM’s Francois Xavier Douin describes the process as based on producing discounted cashflows models to give long-term valuations of stocks irrespective of whether they are growth or value and this is reflected in a relatively low turnover of between 40-60%.
Portfolio managers eliminate style biases in their portfolios and would not take sector bets against the benchmark indices. With $23bn under management in the behavourial finance portfolios and another $10bn in the analyst-based portfolios, JPMF have a wide variety of different types of European mandates. These cover EMU using an MSCI EMU benchmark, Pan-Europe using MSCI Europe and FT Europe as well as a couple of mandates using the Dow Jones Euro Stoxx indices alongside individual country funds.

Where to next?
European equities cover a wide range both geographically and in capitalisation. The issue for investors is whether a single manager can add value across the full geographic range and capitalisation, or whether, as has happened in the US, the market should be split into sectors, differentiated by size, style and, with the additional complication of geographic extent.
The disadvantage of such an approach is of course, the constraints it places on a specialist manager to stick to a sub-class of stocks irrespective of relative valuations. Given the large number of small companies, and the emergence of the new economies, the trend may well be for European equity mandates to follow the US example and be split into core mandates covering the top 300 or so large stocks, together with satellites that explore opportunities in the newer markets and smaller stocks.