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European Equities: Transition management

The transition in market sentiment has now been under way for about nine months. The days when eight out of 10 investors would pay any price for a pristine balance sheet, an unassailable market share and limitless free cash flow from growing global markets – in short, ‘quality’ – seem to be over. Among those ranked top-quartile over three years in Mercer’s Europe ex-UK equities universe, only one manager – Henderson Global investors – made it into the top 10 over Q3 2013. In the much larger pan-European universe no one in the top five during Q3 2013 makes the top quartile over three years.

During these transitions, managers that maintain relatively high rankings across different time horizons tend to be self-consciously style-neutral. Morningstar categorises Henderson’s Euroland strategy as large-cap value. But, in fact, the portfolio’s P/E ratio is not so different from the style-neutral benchmark’s; and P/B is significantly higher, at 1.7 times.

“The key thing is that my return on invested capital is far higher than the market’s,” explains portfolio manager Nick Sheridan. “So the bias of my portfolio is to have a higher growth rate, but I’m paying less than the market for it so, in that sense, I am a value investor. But I have this higher growth rate, a higher cash flow yield and a lower level of leverage in my stocks than the average.”

We are used to seeing these characteristics from quality-growth portfolios, and this also comes through when Sheridan lists his three priorities for analysing businesses. He emphasises the current operating environment and incremental growth opportunities, but puts leverage up-front. That offers an insight into capital-allocation discipline, but when it is combined with a reasonable return on equity it is also a sure-fire sign of a very-high-margin business. And if leverage has been low for a long time, that, in turn, is a sign of high barriers to entry into that business.

These are not the preoccupations of your average value manager. And this comes through in some of the portfolio’s sector exposures, too. It is conspicuously underweight the beaten-up materials and energy sectors. Sheridan does not sound terribly enthusiastic even about Total, the one stock present in his top 10 holdings.

“Total doesn’t look bad value,” he says. “If earnings do nothing, I still get an 11% return on my cash. But until we start seeing significant share buybacks or a better production profile, I find it difficult to imagine why oil-and-gas shares would re-rate.”

A much more significant active weight in the portfolio’s top-10 is Danish jewellery retailer Pandora, part of an overweight to the consumer that, again, we are used to seeing in quality-growth strategies. When Henderson bought it, it was much cheaper than it is now, but even today Sheridan says it delivers a double-digit return on equity – he still sees 6-12 months’ of portfolio life in it.

Sheridan also holds Christian Dior – “not the typical value manager’s stock”, as he concedes. He likes the barriers to entry into its business and the excellent management team, but also the fact that the Arnault family owns 72% and keeps buying back more, and that the company holds a 41% stake in LVMH which itself is worth about the same as Dior’s own market capitalisation.

“Put all of that together and I can buy something on a €25bn valuation that I reckon has a margin of safety of 20-22%,” Sheridan explains.

This overlaps significantly with the sort of thing Brian Hall does at BlackRock – an explicit value strategy that uses metrics favoured by quality managers. While P/B and P/E are lower than the style-neutral benchmark, they are higher than those of the value index. Hall remarks on how the efficacy of different value metrics has diverged through this balance sheet recession, when thinking about enterprise value and cash-flow yield rather than just earnings or book value, has paid off much more clearly.

“I focus very much on cash-flow yield,” he says. “Looking at cash flow rather than reported net income will move you up the quality spectrum because the further you go down into the financial statements, the closer you get to the truth of real economic earnings power.”

Compare Sheridan’s prioritising of balance sheets, and the hidden value he finds in the LVMH stake held by Dior. Hall’s portfolio exhibits something of the same consistency that comes from combining quality with value. “We did set out to design a more consistent strategy, rather than one that would perform well for two years out of five,” he says.

These shared characteristics are exemplified by the nature of both portfolios’ big overweights to industrials – another sector favoured by the quality-growth managers, who like its niche manufacturers with their growing recurring revenues from worldwide customers. For Henderson (10 percentage points overweight) and BlackRock (13 points), the focus is both more cyclical and more domestic, with an emphasis on construction and infrastructure.

“About one-third of our industrials weighting is in infrastructure: Atlantia in Italy, and Vinci and Eiffage in France,” says Hall. “We are of the view that the cash flows offered by their toll roads remain undervalued, but there is obviously also a recovery story there. We have moved away from some of the global niche manufacturers, which have all been significantly re-rated, towards these more European growth-focused names.”

The same themes are evident even in the consumer sectors, with names like Volkswagen and the high-end, fitted-furniture specialist Hayburn Joinery. BlackRock’s underweight in financials is almost entirely explained by the absence of emerging markets-facing banks like HSBC and Standard Chartered, left out in favour of businesses, from Italy’s Azimut to UBS, which key into both the European stock market and the peripheral European economic recovery.

In Henderson’s portfolio the names are different but the feel is very similar – its top 10 holdings in industrials includes Spanish civil engineering specialist ACS and Bouygues, the French construction-oriented conglomerate. Sheridan emphasises the work that ACS’s management has put in to reduce its holding in Iberdrola and recent bond issues that have lowered its cost of debt.

“These companies are cyclical and they are also Europe-facing, certainly,” he says. “But, more importantly, they are also self-help stories.”

The turnaround-value theme, whether stock-specific or industry-wide, is another element that Henderson and BlackRock share. Hall says that BlackRock’s biggest industrials holding is Deutsche Post, a “cash-flow inflexion story”. Being focused on cash-flow yield, he likes companies that are fixing balance-sheet problems to make cash flows more transparent to value. Deutsche Post, not unlike ACS, has been selling bonds to fund its pension liability, reducing its cost-impact on earnings; and it is also unwinding its very high levels of provisioning. Meanwhile, it is Sheridan’s biggest single holding in the Henderson portfolio – and he describes it in terms that resonate with Hall’s strategy.

“Management activity on the pension liability and making the accounts clearer by getting analysts in to sort out the provisioning will make the cash flows more robust and understandable,” he says. “Then you can start to focus on the growing volume of internet shopping deliveries.”

At sector level, both managers have a decent telecoms exposure that one would not find in a quality-growth portfolio at the moment. While he avoids the hyper-competitive French market, Hall holds Telefónica Deutschland for what he sees as the beginnings of some consolidation there. Sheridan also talks about a turnaround.

“We’ve introduced Telefónica in Spain,” he says. “We can begin to see Spain’s average pay-as-you-go spend starting to increase and some consolidation in its non-Spanish markets, especially Germany. Maybe we are at the bottom of the cycle, and we pay a 12.5 multiple and get a yield of 6% and a double-digit return on equity.”

So, while the BlackRock and Henderson portfolios share a quality aspect in their search for value, it is pretty clear how they would differ from a more typical quality-growth manager like Baillie Gifford.  

A couple of areas bring that into relief. The first is healthcare. Baillie Gifford and BlackRock are both fairly neutral: BlackRock has Novartis and Sanofi in its top 10 and another big active position in Merck.  

“They have the highest cash-flow yields that I can find, and it is important to me to find a balance in the fund between defensive value, cyclical value and company-specific cash-flow turnarounds,” says Hall. “I just can’t find much in staples because they are valued to highly, so the healthcare names are there partly on the strength of cash-flow valuations and partly as defensive ballast for the fund.”

Against this defensive value play – Sanofi and Novartis were bought while the ‘patent-cliff’ scare was at its height – Baillie Gifford goes for quality-growth stalwarts in medical equipment, like Carl Zeiss Meditec, the German manufacturer of surgical microscopes, and the genomic-end of pharma, like Roche.

“Eight of our top 10 holdings have some sort of family or foundation involvement, and Roche falls into that group,” says portfolio manager Thomas Coutts. “That allows it to invest through downturns and forge its own destiny. But it also has Genentech and a broader exposure to biological drugs, which are better-protected and therefore less exposed to the patent cliff.”

The second area of difference is in how valuations feed into the sell discipline. Hall has typically sold once a stock’s cash-flow yield has fallen below 5%. “I don’t want to hold a well-known, highly-valued stock that then goes and misses on its earnings guidance,” he says.

By contrast, valuation hardly ever leads Coutts and his team to sell out of a holding.  “If you get your business analysis right, then you tend not to worry so much about the valuation at any given point,” he says. While Sheridan and Hall are seeking out the next quality value opportunities, Coutts and his team are generally hanging on for the compounding, resulting in portfolio turnover of just 15% per year.

Baillie Gifford’s sixth-biggest holding, Handelsbanken, sums this up. Coutts lauds its tricky-to-replicate culture of extreme decentralisation, which has enabled it to expand its practice of putting local branch managers in charge of key lending decisions out of Sweden and into the UK and the Netherlands.

“There is a fundamental truth here about trust and empowerment,” he says, pointing to the resulting mix of conservative loan exposure and organic growth, probably unique in the finance industry. But the other fundamental truth is that it trades at twice its book value.

“We had a big debate about this at the end of 2013,” Coutts concedes. “There is a price at which it gets too expensive, but we don’t think we are there yet.”

The middle-management autonomy and the depth and continuity of the founders’ culture at Handelsbanken relates to that other strong theme in the Baillie Gifford portfolio – family ownership. It resonates through Sheridan’s portfolio at Henderson, too, for example in his seventh-biggest holding, Italian pharmaceuticals company Recordati.

“Family-owned companies often have good capital-allocation processes,” he says. “People are more careful with their own money,” he says.

Coutts calls upon similar logic when comparing its two major food-retailing holdings, Portugal’s Jerónimo Martins, well-known for its fast-growing Biedronka chain in Poland and now moving into Colombia; and Spain’s DIA, bought following a spin-out from Carrefour, since when it has actually been pulling back out of some markets. Carrefour “forced” the business into France, Turkey and Beijing, Coutts says, but now efforts are being focused on Shanghai, Latin America and the domestic consumer.

“Jerónimo Martins has great assets in Poland, so why go to a very challenging market like Colombia?” he asks. “That kind of capital-allocation decision sometimes tells you something about confidence in the existing core business. We like DIA for the same sorts of reasons that we like Handelsbanken: a team of people who had run the business for 20 years suddenly got new freedom and accountability. That kind of long-termism is absolutely crucial to what we do; our own firm is a multi-generational partnership that has been around for over one hundred years.”

But the portfolio would not have managed to cling on to the top half of the Mercer universe through Q3 2013 if it were completely staid and conservative. One clue as to where beta is being picked up is in the five-percentage-point overweight in financials. These are not banks and insurance companies, however, but investment managers of a very particular kind – family-owned holding companies allocating to largely European, largely industrial-sector mid-caps, with strong shareholder engagement. Baillie Gifford’s top holding is Investor AB (established by the Wallenbergs a century ago); and it also holds Italy’s EXOR (owned by the Agnellis), Spain’s CF Alba (owned by the March family), and another Swedish example, Industrivärden.

“One of the Wallenbergs said that they invest with a 50-year view – which puts our 5 to 10-year horizon into perspective,” says Coutts. “That allows them to have a very strong positive influence as stewards for the next generation. On top of that, they trade at big discounts to NAV.”

This offers a valuation cushion for the riskier business of what Coutts describes as “looking for future quality as well as today’s quality”, which is a consistent part of his fund’s own strategy too, and that  represents something of a tilt to risk.

“We have taken holdings over the last year in some earlier-stage industrials, in markets which have not quite consolidated yet – companies like Konecranes or Volvo,” he says. “We have funded that kind of position by taking money out of things like beer companies a couple of years ago.”

Baillie Gifford is explicit about this ‘contrarian’ aspect of its quality strategy and, again, that accounts for the strategy’s ability to thrive for a bit longer than the pure quality cycle. But investors should not expect this to persist.

“Contrarianism is a nice to have but the balance is squarely towards the quality growth,” he says. “We were pleasantly surprised at how well we did in early 2013, but the last nine months have seen more of what you’d expect in a liquidity-driven rally. If we lag in that kind of environment we just hold our hands up: we’re not aiming for consistency of performance – we are aiming for consistency of process.”

We have grown used to the same names drifting to the top of all the time horizon rankings in large-cap equities over the past three years. Right now, the top spots are being shared by those quality-growth managers that have a serious eye on valuation or the long-termism to risk buying tomorrow’s quality today, and by those value managers who tend to steer clear of the trashiest stocks. By the time we revisit European equities next year, it looks very likely that the line-up might have changed more profoundly.

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