European Equities: A heterogeneous marketplace
Top-performing European equity portfolios are both concentrated and very diverse in outlook and composition, finds Joseph Mariathasan
Europe may be comparable in size with the US on a range of criteria, but for equity investors, there is a fundamental distinction that cannot be ignored. Europe is still not one market and, even within the euro-zone, is divided by language, regulations, culture and taxation.
Unlike a typical US small company, a European small company cannot test out a product in one state and then roll it out across a continent unchanged, exploiting the attendant tremendous economies of scale. Yet the domestic marketplace in many European countries is too small to sustain anything but the smallest companies without expanding outside. This means that while companies often become global, they rarely achieve a purely Europe-wide presence analogous to, say, a typical US retail name. A Swedish company might have as much difficulty selling to Greece and Spain as it would to the US, Japan or China. It is obvious which would offer more rewards for the effort. That has profound implications for the opportunities and challenges facing European companies.
It also means that the most successful European equity fund managers often have approaches that seek to identify outstanding companies from bottom-up analysis. In the US, analysis of the domestic macro-economic scenario can be used to help identify outperformers. In Europe, that is irrelevant when the major growth that companies are capitalising on is more likely to be in emerging than domestic markets. Alister Hibbert, a portfolio manager within BlackRock's European equity team, points out that 25% of the revenues from European companies come from emerging markets. Investors can access emerging market growth through German car manufacturers, Swiss watchmakers and Italian and French fashion houses.
The UK, Netherlands, Germany and Switzerland have long-established and well known global multinationals in sectors such as oil and pharmaceuticals that generate a major portion, if not the majority, of their earnings from outside the region. BP, Shell, GlaxoSmithKline, Nestle, Roche, Unilever - the list goes on. Germany might be renowned for engineering excellence, but regions such as Scandinavia have also established competitive positioning.
Magnus Larsson, manager of Nordea's European Small and Mid Cap Equity fund, recounts meeting a German engineering company. "We were also looking at a competitor based in Sweden," he recalls. "Surely Swedish companies cannot compete with German engineering? But when we said that the MD became very animated, talking about his Swedish competitors. It was clear he was finding them a challenge."
In fact, RCM, which has a pure stockpicking approach, has 25% of its portfolio in industrials, of which roughly half are Scandinavian. "The market leading companies for many different types of industrial services are in Scandinavia, such as Atlas Copco, a Swedish company that is the market leader for compressors, construction and mining equipment, power tools and assembly systems," says Thorsten Winkelmann, who manages RCM's European Equity Growth fund.
Finding companies that are able to compete globally and may have to because their domestic market is too small is the objective of many stockpicking strategies with concentrated portfolios of 60 or so stocks. Nonetheless, a comparison of successful stockpicking approaches for European equities is fascinating because the approaches are so different.
RCM is a pure bottom-up stockpicker with no active sector or country allocation. Winkelmann's fund seeks companies that will outgrow the market in earnings and cash flows over 3-5 years or longer, rather than just a cycle. Currently it has 64 stocks in the portfolio and turnover is around 30%.
"Creating and analysing a new investment idea usually takes 4-8 weeks," he says. "We are not in a hurry to buy and we need to ensure every case is waterproof and the valuations are reasonable." Stock positions are reduced when valuations are seen as too demanding or a better investment opportunity comes along, and sold out completely as soon as the investment case is broken. What determines the weighting in the portfolio is a combination of three factors: the managers' conviction; the upside potential they see over 3-5 years; and the market cap and liquidity. "The Weir Group is a phenomenal UK engineering company but as it is a mid-cap, we cannot have the highest weighting in the portfolio, as we need to ensure we have sufficient liquidity for redemptions and subscriptions in our retail funds," Winkelmann explains.
RCM's European process is run in a similar manner to its global strategy, with a heavy emphasis on ‘Grassroots Research', an in-house research facility that undertakes consumer research related to companies and products that the firm is following. Around 30 Grassroots studies are completed each month by a 10-strong in-house team and a network of 300 part-time independent researchers, conducting quantitative market research or interviews with industry contacts from pharmacists and travel agents to purchasing managers and cardiologists. A lot of studies are implemented on an ongoing quarterly basis. One example is Swedish clothing retailer H&M.
"They tried to enter the US market in 1999-2000 and failed," says Winkelmann. "They started another attempt in 2006-07 and we would like to find out whether the brand is doing better in the US now and is choosing the right locations. A Grassroots initiative has been set up where customers coming out of 25 H&M stores are interviewed every quarter, alongside sales managers, suppliers, and others."
Such studies tend to focus on market-leading companies in consumer and healthcare that are driven by retail consumer preferences. In medical technology, for example, it can make sense to ask hospitals and doctors about the prospects for companies' new drugs or treatments, whereas it would make little sense to undertake a similar study in the oil and gas sector. Within their portfolio, between a third and half of holdings are supported by Grassroots Research.
The key driver in stock selection is the ability of stocks to outperform over the long term due to their structural growth. Winkelmann gives an example: "Novo Nordisk benefits from two long term structural trends. Firstly, the growing patient population around the globe for diabetes with the number of people suffering from diabetes type II estimated to grow by 50% by 2030. Secondly, insulin in the past was human insulin, which patients found was associated with weight gain. In contrast, the analogue insulin that Novo Nordisk and others have created can reduce weight. As a result, analogue insulin is achieving higher selling prices and lower production costs. As soon as more patients shift to analogue insulin, the company's margins will improve." The economic cycle is irrelevant for a company like this.
RCM's approach has resulted in an overweight in industrials, consumer discretionary and consumer staples, with nothing in the telecoms sector, no oil majors and no large pharma apart from Roche. The industrials exposure is very significant but as Winkelmann explains, the sector is very diverse - and RCM's fund excludes large mining companies completely. "These companies need more and more capex spend on the infrastructure of their mines whilst the grades of ore are getting lower and lower. They did not spend sufficiently on infrastructure in the 1980s and 1990s so they now need to spend on a continuous level to maintain production at current levels." Instead, Winkelmann prefers companies that will benefit from the extended capex spending, which is the reason for their heavy Scandinavian exposure as the equity market has a lot of capital goods companies.
BlackRock's 14-strong European equities team is, like all BlackRock's teams, autonomous from the rest of the organisation. All 14 undertake research, with sector responsibilities allocated among the team, using a bottom-up fundamental approach that also takes into account macro factors. There are three sources of macro data that are particularly important for the strategy: leading economic indicators including inflationary expectations and other bond markets signals; market flow data obtained from BlackRock's custodian, State Street; and screening across a range of factors including commodity prices and changes in other leading indicators.
"Screening market flow data is very helpful in pointing out areas of the market with strong overcrowding or under-representation," says European equities head Nigel Bolton. "The biggest example was in Q1 2009 when there was a large underweighting in financials. That changed in December 2010 and January 2011 and, combined with undervaluations, suggested that these valuations could swing back very quickly." On the importance of changing macroeconomic fundamentals, Bolton notes that the core countries of northern Europe have been the region's growth engine and that his team has had a negative view of southern Europe's consumers since 2007. "We need to keep abreast of how that scenario is developing," he says.
BlackRock's stockpicking is based on first screening the universe, based on factors such as value, growth and momentum, looking at changes in analysts' expectations to produce a universe of 300 stocks. These are researched in detail, looking at valuations, key market drivers, revenue growth, margins, financial structure and cashflow and risks.
Companies are given a rating and a price target over a one-year horizon, leading to portfolios of 45-60 stocks and a turnover of 140%. Risk management is based on comparisons with the benchmark index, the MSCI Europe and, in particular, the use of their in-house software to search for any concentrated specific exposures (such as gold, the yield curve, inflation expectations) hidden within the portfolio. What the portfolios do show is exposure to large stocks such as Shell, BP, Rio Tinto and Xstrata - but as they argue, their active bets against the index are much more in the mid-cap space.
Larsson and his colleagues running Nordea's European equity strategy, like RCM, are seeking companies that can provide structural rather than cyclical growth and they also have a similar number of holdings (around 60) with a holding period of 3-4 years. But the key aspect of their approach is understanding who the winners and losers are within a value chain.
"We use a qualitative analysis that relies on our 300 or so company meetings a year," says Larsson. "We seek to understand where a company sits on the value chain and who within that chain has the strongest pricing power, which means that our analysts can find meetings with poor companies as useful, if not more useful, than meetings with successful ones. They offer information on the key issues such as barriers to entry, the degree of consolidation and the pricing power companies have over customers and suppliers: we need to understand the relationships between a company and its suppliers, its suppliers' suppliers and so on, and its customers. The auto-industry could be analysed all the way back to mining companies - but in a large team there would be sector analysts covering mining, steel manufacturers, car manufacturers and retailers who typically would not speak to each other."
One good example of a company with strong purchasing power is the UK's Croda, which has a global patent for the active ingredient in anti-wrinkle cream. "Companies such as Dior, Lancome and L'Oréal are marketing machines, but it is Croda that gives their products functionality," Larsson notes. "I don't know Croda's margins but it must be larger than 50%."
Another area that Nordea is very bullish on is digital media. It sees the two satellite companies SES Global and Eutelsat as major beneficiaries of the drive to high definition TV. "High definition TV requires a high bandwidth, which requires satellites rather than cables," says Larsson. "We invested in SES which has a similar business to Eutelsat but lower valuations." The barriers to entry for a newcomer to compete are very large: "You would need 50 satellites and currently only the Russians are launching satellites."
Larsson's team follows around 120 companies at any one time, waiting for valuations to become attractive. That can take anywhere up to five years. "Time is our friend," says Larsson. "From time to time, there are short-term fads. But if you do not overpay and keep a sharp eye on valuations, you will outperform over the long term."
While Nordea's bias is towards growth, it prefers companies with strong cashflows. "Two things that do stand out about our style are, firstly, we see very high risks in leverage, so as a result our portfolio is much stronger in terms of balance sheets than the benchmark. If a risk manager says we are taking on risk by deviating from the benchmark, I ask what planet are they on? Secondly, we have high momentum as we are selecting companies with high earnings growth."
The value chain analysis, combined with detailed absolute and relative valuations and analysis of changes in earnings momentum, is the core of the firm's stockpicking approach. Macro research influences the size of holdings - so the stake in Norwegian oil services companies has increased from 1.5% to 2.5% to reflect bullishness on oil prices, for example. Portfolio risk control is focused on optimal use of the risk budget in regards to tracking error, liquidity, volatility and unintentional biases.
Placing your bets
All three managers show that successful European equity portfolios, although relatively concentrated, can encompass very different approaches to stock selection. Given that each portfolio looks so different from the others, institutional investors might ask themselves whether there is merit in combining different managers - as would be common in the US institutional marketplace - or placing all your bets on just one.