Surprisingly, Martin Steward finds that it was just about possible for pan-European contrarian value to hang in there during 2011's quality-growth world
At first glance, our two top performers in pan-European equities over three years could not look more different. Portfolio P/E ratios alone tell the story: ING Investment Management's Europe Opportunities, a contrarian value strategy, is at around eight times (it runs a 6.2% dividend yield); Allianz Global Investors RCM's Pan-European Growth strategy is at just over 13 times.
RCM's strategy scores quite highly on traditional growth metrics like EPS growth, but there is also an emphasis on characteristics identifiable as ‘quality' - high return on capital over cost of capital, good free cash flow - which have generally outperformed over the past 12 months.
Healthcare companies with minimal exposure to the ‘patent cliff' are a good example, and RCM owns one of the most popular in Novo Nordisk, the market leader in insulin products. The next generation is expected to include 50% more sufferers of type-2 diabetes, and Novo Nordisk's market-leading products like Victoza, a synthetic insulin already on the market, and Degludec, a long-lasting synthetic currently in clinical trials, significantly improve side effects and sell at a premium. "This is what I call structural growth in cash flows and margins, largely independent of the growth cycle because diabetes doesn't care about economic cycles," says Thorsten Winkelmann, RCM's head of European equity growth.
Industrials is another sector well-liked by quality-growth strategies and RCM, with a 15 percentage point overweight, is no exception. It holds everything from export-oriented capital goods and freight specialists to domestic-focused outsourcing, business service and staffing companies (to stay the right side of recessionary forces and government efficiency drives, especially in the UK, where it owns G4S, Serco and Capita, for example). Like many quality-growth managers, while RCM is underweight for the materials sector, it exploits the long-term growth associated with emerging market industrialisation through industrials exposed to the mining capex cycle, like Sandvik and Outotek, especially if they have adapted business models to dampen shorter-term cyclicality, as compressor technology market leader Atlas Copco has.
"The beauty of the Atlas Copco business model is that it is very lean," says Winkelmann. "It outsourced most of its production and only does the final assembly, so as soon as there is weakness in the order book it can adjust its cost base in seconds."
Some of the industrials, like France's Bureau Veritas and Switzerland's SGS, which both specialise in testing and certification, or Ingenico, the French point-of-sale technology provider that recently announced a deal with PayPal in the US, point to a broader portfolio exposure to global trade and the global consumer. Indeed, of RCM's top 10 holdings, five are consumer staples stocks (Reckitt Benckiser, BAT, Danone, SABMiller, Carlsberg), two are discretionary (Inditex, H&M), and all tap into secular global themes.
"We are seeing a global redistribution of income," notes Winkelmann. "In Europe and the US the average real disposable income is stabilising or even shrinking, whereas it is rising in emerging markets. In addition, inequality is increasing. If you put on top-down glasses - which we don't - you can see how our barbell position makes sense: on the one hand we are invested in Louis Vuitton and Richemont, and on the other Inditex and H&M for the value-for-money proposition."
Speaking of value-for-money, these are well-loved, pricey sectors - and this presents Winkelmann quite a challenge. He likes Hugo Boss and Burberry but "struggles with the valuations". Nonetheless, in common with many other quality-growth managers, he finds justification in what he is paying for luxury goods: 17 times earnings for LVMH "looks expensive" against the MSCI Europe's 10 times, he concedes, but it feels very different when you realise that it has always traded between 15 and 25 times and is a better business today than ever before.
"It made some acquisitions to strengthen its portfolio, it has outstanding sales in emerging markets, and there is no reason to believe that this quality should be at risk," he argues. "Neither buyers nor suppliers have bargaining power, barriers to entry are high, and the threat from within the industry is relatively low."
Unsurprisingly, value manager and head of ING's equity specialities boutique Hans van de Weg won't go anywhere near these sectors. His overweight in consumer discretionary is actually about media and publishing (Vivendi, Reed Elsevier); and his consumer staples underweight of 9.5 percentage points is within striking distance of his self-imposed 10-point limit.
"I think a big part of that growth is priced-in," he argues. "They generally are fantastic companies but my starting point is that it's better to look at the other end of the market rather than chase these high expectations stocks."
The same applies to Van de Weg's underweights to Germany and industrials; he likes the well-rehearsed industrials' emerging markets theme - he just thinks that expectations for margins now seem over-optimistic.
"Investors like to extrapolate current success too far into the future, and they feel pressure to cut losing positions or positions that aren't moving too soon," he says. "They also face career risk, and prefer to tell their bosses, wives and friends about the good performing stocks in their portfolios. From a behavioural finance point of view, that's the opportunity; we buy the fear and sell the greed of other market participants."
It has not paid to buy fear over the past year. And yet ING's strategy has held up pretty well over the shorter time horizons in the Mercer table, as a quick glance at the devastation suffered by some other portfolios that make the top 15 over three years attests.
Like most value strategies, Van de Weg's suffers most when there is sector-specific momentum in the market. The tech boom of 1999 and the China and materials hype of 2006-07 were difficult. While 2011 saw quality-growth momentum, its overwhelming characteristics were high volatility and a lack of direction - and alongside its main strategy of exploiting mean reversion over a three to five-year horizon, the ING portfolio maintains trading-oriented positions to exploit short-term mean reversion.
Crucially, these shorter-term positions only go into the portfolio if they can be justified for the long term, too, which helps to limit low-quality and value traps. As a result, while there is a slight overweight to financials - the most volatile but also the most painful sector of 2011 - it is nowhere near as large as one might expect from a contrarian value strategy. Van de Weg points to uncertainty about how diluted shareholders will be following Basel III-related capital raising, and the general regulatory pressure to return to "utility-type" business. Returns will struggle to exceed the cost of capital, which means that a P/E of six times, dividend yields of 6% and a P/B of one will look like fair value. While the sector trades below book value, it is not the "wildly undervalued" opportunity he needs to justify a long-term holding and so it does not figure in the short-term volatility strategy, either.
"One of the most dangerous places to be contrarian is financials," he concludes. "That's a conviction I've held for quite a number of years and it's saved me over recent times."
This particular sector example hints at a broader characteristic of the strategy, which sees initial contrarian value screens subjected to bottom-up analysis of balance sheets, franchises and cash flows to avoid blindly chasing unsustainable dividend yields. "We describe the strategy as conforming to the ‘three Cs': concentrated, contrarian, but controlled," he explains.
But if he spurns banks as their ‘utility-type' business model gets priced-in, it is striking that actual utilities are a 9.8 percentage point overweight, close to his limit. Winkelmann at RCM is zero weighted, reflecting the feelings of most growth and quality managers: return on capital may look respectable, he warns, but that is partly because companies like EON and RWE have neglected their infrastructure for so long, and partly because investors fail to account for an imminent rise in the cost of capital.
"It's a sector that people hate, and for many of the right reasons - earnings revisions are negative at the moment," Van de Weg concedes. "It's quite clear that a lot of utilities have moved up in our contrarian screens over the past 12 months."
But where does he find the quality that will protect him against value traps? Not where quality-focused managers do, in sub-sectors like UK water, where he feels expectations are now too high. "There are other areas in European utilities that fit with the contrarian approach while ensuring that the balance sheet and cash flow is strong enough to pay dividends or pay down debt," he says. "Sell-side analysts and investors are generally too short-termist, and when the market is short-termist, I try to lengthen my horizon. If you model individual stocks you definitely can pick stocks that offer the right level of quality for very good valuations, with significant upside just a few years out, based on scenarios that are more conservative than the Street's."
In terms of his portfolio's top-10 holdings, this means companies like Gdf Suez and Suez Environnement - perhaps a recognition of the potential growth in areas like renewable energy and water treatment. In financials, utilities and telecoms, another out-of-favour sector, Van de Weg claims that careful bottom-up stockpicking has protected his contrarian value tilt through 2011 - and the performance numbers seem to back him up. He may have built a portfolio that is well-positioned as better-quality value begins to edge back, in both its performance and its representation in style-neutral portfolios.