European Equities: Debating ‘quality’
Martin Steward finds three strategies, each with impressive longevity, illustrating three very different interpretations of ‘quality’ in European equities
Thanks to market behaviour over the past 3-5 years, it has become commonplace for top-performing strategies to pursue ‘quality growth’. The idea is superficially simple: ‘quality’ means dominant positions and pricing power in particular niches; ‘growth’ means extending that dominance into new markets and locales by spending the free cash generated by the core ‘quality’ business.
However, as markets begin to price-in a recovery it is worth remembering that the ‘quality growth’ label obscures plenty of debate and difference. Its recent dominance has probably owed more to returns to style risk than stock risk, but that may be changing as market correlations decrease – making it more important to focus on where quality-growth managers differ than on where they agree.
The positioning of this month’s featured managers allows us to consider those differences as they apply to three crucial aspects of quality-growth investing: the appropriate valuation of long-term compounded earnings; the most effective ways to expand into new markets and regions; and the true nature of technological advantage.
The 14 percentage point overweight to France in Paris-based Comgest’s pan-European equities portfolio looks like home bias. It isn’t – portfolio manager Franz Weis is German and half his team is non-French. More importantly, Comgest looks for at least 10% earnings growth over the next five years and the pickings in France are rich - its top-10 holdings include Dassault Systèmes, L’Oréal, Essilor International and Sodexo.
“It’s simply a fact that France boasts many fantastic quality-growth companies – as does Denmark, where we are also overweight,” says Weis. “I think you’d see an overweight to France in any portfolio with a hint of quality growth.”
Not necessarily. David Dudding, portfolio manager on Threadneedle Investments’ Europe ex-UK high alpha strategy, identifies with the ‘quality growth’ label “100%” and is seven percentage points underweight France.
“Anything that’s not state-related in France will be among the best-managed businesses in Europe,” he concedes. “We own L’Oréal, Air Liquide, Legrand, Schneider and LVMH - all quality compounders. I find Essilor, Sodexo and Dassault a bit expensive. Essilor is the single best company I know of in Europe, but I’d be paying a very high multiple for it.”
Weis notes that it is in the nature of stable earnings compounders to seem over-valued according to short-term metrics. Comgest has held Essilor for 14 years, and while Weis did reduce its position last year as it ran up to 25-times earnings, he says it would be misguided to sell completely: “It would be extremely difficult to find another good point of entry, or alternatively to find another company with a similar quality-growth profile.”
Dudding agrees in principle. “Compounding explains how a stock on a P/E of 20-times can be offering tremendous value,” he reasons. Alexander Darwall, who manages Jupiter Asset Management’s European equity growth strategy, similarly notes that Novo Nordisk traded at 30-times earnings around the turn of the century and trades at 27-times today, and in the meantime has seen its share price increase by 600%. But the point about the difference over top-quality French firms is that this difficulty of valuing compounding earnings, as well as subtle differences in investment time horizon and sector biases, leads to important disagreements over what is cheap and what is expensive.
Darwall articulates another sentiment that is shared by all three managers, but implemented differently: “Patience is the key to the way a strategy like ours works.”
Jupiter and Threadneedle agree that the underperformance of Fresenius in the face of uncertainty around health spending in the US budget offers a chance to top-up. “It’s a great compounder that just got cheaper,” says Dudding. Darwall adds that the firm’s subsidiary, clinical nutrition specialist Kabi, is not only free of the pressures of pharma spending but part of the solution, as its products improve the efficiency of other clinical treatments. Similarly, Comgest and Jupiter agreed on buying Experian through 2011-12 when the market was panicking about European banks: the financial sector accounts for only 40% of its business, and it is successfully seeking growth elsewhere.
But Comgest alone has gone for the most obvious value play in Europe – Spanish, Italian and Portuguese companies with limited domestic revenue and an emerging markets presence: it has a Portugal overweight (Jerónimo Martins, with its Biedronka supermarkets in Poland) and almost 9% in Spain, including its top holding, Inditex.
“We have been able to increase our position in Inditex because so many take the top-down view that they don’t want to own Spanish companies,” says Weis. Spain accounts for only 20% of Inditex sales, and it adds 10% more international store space per year – half of it in Asia.
“Inditex is probably the best fashion retailer ever on this planet,” concedes Dudding. “But I find it very hard to own fashion retailers.” This is a difference over value in peripheral Europe, where Threadneedle is underweight. It is a difference over the inherent fickleness of fashion – Dudding does not own H&M, either, and he contrasts the world of fashion with some of the staples firms he owns, which have been around for more than a century. But it is also a difference over how best to get emerging market exposure through European companies.
“Inditex wouldn’t be the first fashion retailer that has attempted to go international and failed,” he says. “Think of GAP. Why can’t the Chinese start a great discount fashion retailer?”
A similar difference of opinion centres upon Threadneedle’s top holding, Anheuser-Busch InBev, and Comgest’s seventh-biggest, Heineken. Heineken trades at a discount to InBev, probably because it is perceived to be the more Euro-centric international brewer.
“Investors haven’t factored-in that it has bought FEMSA in Latin America and APB in Asia,” Weis suggests. “Two-thirds of its sales come from emerging markets now, and it has the advantage of the world’s best-known beer brand.”
Sporting a global brand will only get you so far in a localised market like beer, counters Dudding. And as for FEMSA and ABP, Dudding argues these were the only businesses available for this latecomer to emerging markets: “[InBev] owns 50% of Modelo and is now trying to buy the rest, which represents 60% of Mexico’s market – it already owned the better business.”
Bottom-up differentiation like this is important because the top holdings of all three managers tell the simple story that the best European companies are not focused on European customers. Comgest holds Sodexo, whose canteen business is much more global than Compass Group’s, and therefore appeals to multi-national corporations looking for a single worldwide operator. Jupiter’s seventh-biggest holding is Vopak, a play on divergent global natural gas pricing. Both have Novo Nordisk, which enjoys 70% of China’s insulin market. And Jupiter and Threadneedle both hold big positions in Syngenta, whose soybean seed technology sells successfully in North America and Brazil, for end markets like China.
“The types of companies we have find it easier to go global,” says Darwall. “We don’t like utilities and telecoms with all their capex in the ground – we prefer intellectual property which is easier to get out there.”
But that raises a ‘chicken-and-egg’ question. Is global reach in itself an indicator of this kind of quality? Or is quality, proven at home, necessary to sustain global reach?
Dudding warns that global exposure can distract from the real task of identifying quality.
For example, he prefers Air Liquide to Linde, the stock Comgest holds in industrial gases.
Dudding accepts that Linde enjoys an advantage in emerging markets. He even concedes that Linde will “probably” outperform over the next 3-5 years. But he did not like Linde’s expensive, equity-funded acquisition of Lincare last year. “Would it be worth selling Air Liquide for the possibility of marginally better growth, if it comes with the risk of management making what we thought was a terrible allocation of capital?” he asks.
Even in staples, where so much focus is on taking dominant brands global, Dudding emphasizes that the best companies are just as effective at introducing products that push up margins at home even as consumers are struggling. Europe accounts for 80% of Nespresso sales, he notes.
“Good consumer staples are very effective at dealing with recessions in innovative ways,” Dudding says. “Unilever is basically a product of the Great Depression, and in Greece they’ve been flying teams in from Indonesia and Argentina to work on the local marketing strategy because they think it could become like an emerging market again.”
He goes on to observe that while L’Oréal could double its free cash flow yield to 10% simply by halving its promotion budget, which currently sucks up a third of its sales revenue, it would kill the business by losing consumers. By contrast, he worries that InBev might not be spending enough on promotion. He is beginning to look more favourably on companies like Pernod-Ricard because it is much easier to trade domestic consumers up to higher-margin products in spirits than in beer.
This complicates the differences over Inditex. Weis argues that Inditex’s success is as much about quality as it is about emerging markets – after all, it has maintained positive like-for-like sales growth at home. Its widely-admired, sophisticated in-store data collection and local sourcing (from Spain, Portugal, Morocco, Turkey) enables a fast response to customer preferences that significantly reduces end-of-season discounting.
There seems to be a broad definition of ‘innovation’: from pure scientific innovation into innovation in product-design, marketing and branding. Jupiter’s top-three holdings are Novo Nordisk, Novozymes and Syngenta, businesses that are all about science-based intellectual property. Can we speak of Inditex’s value chain, Heineken’s brand – or Pernod’s premium vodkas – in the same breath? Do they confer similar advantages when it comes to expanding globally or ‘exploiting adjacencies’ – taking dominant know-how from one market to another?
This question deepens as we look at active sector weightings among our featured managers. It is Comgest, not Jupiter, that runs a 14 percentage point overweight in information technology, a hotbed of innovation and adjacencies. Dassault Systèmes is pushing its 3D design software beyond the automotive and aerospace sectors into markets as diverse as medical technology, household goods and mining (it recently acquired Canada’s GemCom); and Weis favours its second-biggest holding, SAP, on the strength of its “major innovations” in cloud products, mobile products and in-memory databases.
But what Weis particularly likes about software is the extremely low fixed costs, which can be controlled aggressively at the hint of any downturn – as SAP showed in 2008-09, successfully protecting its bottom line from a slump in licence sales. This reflects quite closely what Weis likes about Inditex – flexibility to adapt to short-term cycles through technological and business-model innovation – but the IT overweight perhaps suggests that Inditex is one of the exceptions that prove the rule that Comgest prefers to get its innovation through pure tech.
A willingness to extend the innovation theme further away from pure IT is stronger in the Threadneedle and Jupiter portfolios. Darwall picks out Experian because of its success in taking the data it gets from its credit-scoring work and selling it to telecoms and utilities that want to know their customers better, and the public sector that wants to clamp down on social-security fraud. He also cites the ability of Provident Financial, thanks to its 130-year history of doorstep lending, to move into the credit card-acquiring business with Vanquis Bank. Similarly, he argues that publishing company Reed Elsevier is ahead of the game in going digital. “It can now go to a university library and put up prices by 4% because it’s able to show them that it had 200% more downloads last year,” he says.
Industrials like Vopak, Novozymes and Schneider represent a massive, 24 percentage point overweight in Jupiter’s portfolio. Materials plays an important role in Threadneedle’s – an eight percentage point overweight from positions in Air Liquide, Syngenta, Bayer and Brenntag. Their major overlap is exemplified by Syngenta, which Dudding describes as capturing market share consistently over the past decade because it has spent more on R&D.
“Technology is about intellectual property, so why isn’t Syngenta categorised as technology?” he asks. “The European company that issues the most patents is Novozymes, which gets categorized in chemicals or industrials, but never as tech.” Darwall concurs: “These are technology companies, big time.”
Nonetheless, they are technology companies with more ‘industrial’ capex and fixed-cost characteristics than Comgest’s software companies, bringing an element of cyclicality into these two portfolios that seems to be absent from Comgest’s. That is something to ponder as markets begin to price-in a recovery.
Will investors rotate out of these ‘quality’ positions less readily than in past cycles, having learned that they are not necessarily ‘boring defensives’, but innovators in a wide range of industries? Perhaps.
What is certain is that these three portfolios show that there are many, often conflicting, ideas about how to play the themes that define ‘quality’ in Europe today: exposure to emerging market growth; innovation and adjacencies to maintain growth at home; the primacy of intellectual property. The choices portfolio managers make can be the difference between between one company and its competitor, but also the difference between distinct stylistic tilts that will determine relative performance as the market makes its next transition.