TR European Growth Trust — Making changes but keeping successful approach

During 2021, TRG’s board conducted a strategic review with the aim of understanding how to maximise the trust’s appeal and ensure it is well positioned for future success. The review focused on the trust’s investment objective, operations and positioning in the market. The board concluded that the investment objective and policy remained fit for purpose and that Beckett’s team and Janus Henderson were doing a good job in terms of implementing it. However, the review has resulted in several recommendations that the board sees as key in boosting private investor ownership, which could be an important lever in narrowing the trust’s discount to net asset value (NAV), given retail investor money tends to be more ‘sticky’ and long term, often supported by regular monthly savings. The main developments are as follows:

Looking at TRG’s benchmark-beating 12-month NAV performance in the context of a market that has gyrated between ‘value’ and ‘growth’ styles, Beckett argues that valuation still matters. ‘At the end of last year after the first vaccine trials were successful, our performance was very good – the world was looking towards increased US infrastructure spending and the hope of a post-COVID economic recovery, so there was a shift towards value and cyclicals and we did better,’ he explains. More recently, with higher inflation fears, recession worries and a flattening of the yield curve, the manager says ‘growth at any price’ stocks have been going up and up again. However, Beckett says, ‘we are not chasing stocks on 60–70x P/E, and we are not assuming discount rates of 1–2% to make high valuations stack up’.

The manager notes that the valuation disparity between the cheapest and most expensive deciles in European small and mid-caps (using a number of metrics) has continued to widen, with stocks in the 10th percentile on average trading at a forward P/E valuation 5.5x higher than those in the 90th percentile at end-September 2021. ‘A lot of companies are priced for perfection’, he says, noting that one former TRG holding, Sinch – a Swedish company that operates a text messaging service for clients such as GP surgeries – was at a forward P/E of c 70x before a small sales miss in late October caused its share price to decline by 20% in a single day (it is yet to recover). However, this is not to suggest that TRG only holds companies whose valuations are low: ‘There are names in the portfolio that are on high P/E multiples, but I think the growth justifies it,’ Beckett explains. ‘There is cashflow generation that allows the likes of HelloFresh (on a forward P/E of c 50x) to spend on marketing and thus drive their sales further. Cashflow generation is a key differentiator for us.’

Considering the outlook (although speaking before the emergence of a new COVID-19 variant in Southern Africa rocked markets in late November), Beckett says: ‘Overall I am still pretty upbeat – when you see c 7% earnings growth and 4% GDP growth, it doesn’t stack up – you would expect mid-teens earnings growth in that environment.’ The team remains happy to buy growth at a reasonable price, and does not expect massive interest rate rises to happen in a hurry, particularly in Europe where the inflationary pressure is less than in the United States or UK. ‘We could have a period of significant outperformance if people get a bit more relaxed,’ the manager concludes.

At 31 October 2021, there were 134 holdings in TRG’s portfolio, in the middle of the indicative range of c 120–150 and up from 130 a year previously. As a broadly diversified portfolio, the top 10 holdings (Exhibit 1) currently make up just 18.0% of the total (down from 19.0% at 31 October 2020), with only four positions above 2% of the portfolio.

Beckett and the team have been active on the purchase and sales front so far in 2021, partly driven by a high level of merger & acquisition (M&A) activity. Between 1 January and 30 September, 26 new holdings were purchased and 29 were sold, six as a result of M&A bids. Since the end of September, top holding Aareal Bank has also been bid for by a private equity consortium, which if successful would see it too exiting the portfolio. Belgian insulation maker Recticel (the fourth largest holding) has so far rebuffed the advances of Austrian family-owned plastics firm Greiner, whose bid is now being scrutinised by EU competition authorities. Beckett sees the high level of M&A as proof of the value on offer in the portfolio, with private buyers taking advantage of the hesitancy of public market participants to scoop up attractive assets.

New purchases have mainly been in the quality growth segment (12 new holdings), including German online cycle equipment store Bike24, bought at initial public offering (IPO) in June. Also bought at IPO were Grenergy Renovables (a renewables focused utility company) and Apontis Pharma, which makes single-dosage drugs. Both of these are in the early cycle segment, where five new holdings were added, reflecting a smaller number of attractively valued opportunities. Seven purchases were in the turnaround segment, including Barco, a Belgian firm that makes laser projectors for cinemas, webcasts and videoconferencing equipment, which had seen sales growth slow because much of its customer base was working from home. Only two new stocks were added in the mature space, including Swedish medical technology company RaySearch Laboratories.

Cerved, Dialog Semiconductor, Euskaltel, Sbanken, Schaltbau and Tarkett, many of which had been long-term holdings, were exited after takeover bids. However, the majority of sales (16 of the 29) were as a result of profit-taking in positions the team considered to have reached fair value, such as Dermapharm, Embracer, Stratec and Swissquote. Four holdings were exited after their initial investment thesis failed to play out, including krill farmer Aker BioMarine. Finally, three positions were sold in order to take advantage of better opportunities elsewhere.

As a bottom-up portfolio, TRG’s geographical and sector exposures (Exhibits 2 and 3) are an output of stock selection. However, with stock selection itself predicated on finding attractive companies whose valuations do not reflect their long-term growth prospects, this shows through in the portfolio weightings, with an underweight in Sweden (c 6pp versus the benchmark) because it is ‘expensive’, and a clear preference for more cyclical sectors such as industrials.

As shown in Exhibit 5, TRG is a true small-cap portfolio, with two-thirds of holdings having a market cap below £1bn. Beckett says he is currently finding stocks in the £800m to £1bn range to be the ‘sweet spot’ in terms of opportunities.

Looking at TRG’s portfolio metrics versus the benchmark, the manager explains that the trust’s higher portfolio yield (2.8% vs 2.5% for the index) reflects its focus on cash-generative companies. The lower forward P/E rating is to be expected in a value-orientated portfolio, although the fact it lies in the mid-teens underlines that the team is not buying ‘deep value’ stocks. While return on equity (at 7.4% vs 8.1%) is lower than the index, Beckett notes that ‘we are looking for an improvement, not an absolute. When you are trying to buy undervalued companies where the market perception is wrong, a pick-up in RoE can be an inflection point.’

For FY21 (ended 30 June), TRG posted NAV and share price total returns of +63.5% and +79.5% respectively, marking a strong recovery from FY20, when the comparable returns were +3.0% and 2.5%. Updating the numbers to end-November, TRG’s 12-month NAV and share price total returns of +18.6% and +12.8% (Exhibit 6) remain healthy, although the beginning of the strong ‘vaccine rally’ in November 2020 is now outside the 12-month period, and more recently the market has paused for breath with fears over supply chain disruption, availability of skilled labour, rising inflation and now the new omicron coronavirus variant. As such, the majority of the 12-month gains were made between December 2020 and August 2021 (Exhibit 7).

Returns relative to European small- and large-cap indices as well as the broad UK market also show a divergence over the short and longer term, with TRG lagging all the indices shown over one, three and six months to end-November, while outperforming (with the exception of the 12-month share price total return versus the European small-cap index) over one, three, five and 10 years (Exhibit 8). This strong long-term record (albeit containing periods of volatility) has translated into annualised NAV and share price total returns of c 15–22% over three, five and 10 years (Exhibit 7, right-hand chart).

In line with the more muted returns in recent months, the top 10 positive stock contributors added 5.1% to relative performance in the nine months to end-September (9M21), while the 10 largest detractors had a negative impact of -3.3% versus the benchmark. This contrasts with calendar 2020 (CY20), when the top 10 contributors added 14.4% and the biggest detractors cost -7.9%. Investors should note that owing to the highly diversified nature of the portfolio (134 holdings at 31 October 2021, with the 10 largest positions making up only 18% of the total), individual stocks are unlikely to have an outsized impact on overall returns in the short term, although over the long term they may add significant value.

Beckett points out that the winners in 9M21 have been quite different from those in CY20, when ‘stay at home’ stocks such as home furnishings website Westwing, online pharmacy Zur Rose and meal kit provider HelloFresh topped the list of positive contributors. The three biggest detractors in CY20 were Aareal Bank, ferry company DFDS (banks and travel stocks both having been out of favour in the pre-COVID-19 vaccine phase of the pandemic) and not holding vaccine beneficiary BioNTech. In 9M20, the top three contributors were Flex LNG (a beneficiary of higher gas prices), online travel agency eDreams Odigeo (as travel stocks staged a recovery) and digital display advertising firm Criteo. More recently, PVA TePla – which makes silicon/silicon carbide furnaces for semiconductor foundries – has been ‘flavour of the month’, according to Beckett, with its share price rising by c 77% between 30 June and 1 December 2021. On the negative side, energy distributor Fjordkraft will take time to pass on increased input costs, Aker BioMarine was sold after failing to live up to its promise and Basware, which makes payables software, is ‘at a massive discount to peers’, according to Beckett, and thus offers re-rating potential.

TRG is one of four funds in the Association of Investment Companies’ (AIC) European Smaller Companies sector. Analysis using Morningstar’s style box (split into nine squares covering large-, mid- and small-cap and value, core and growth styles) puts the trust in the small-cap core square (suggesting more of a balance between growth and value), while the peers are all more towards the mid-cap growth area. In performance terms, TRG ranks second for NAV total returns over three, five and 10 years, and third over one year.

Interestingly, the only fund to outperform it over the three longer periods, Montanaro European Smaller Companies (MTE), is the most polarised from TRG in terms of its high-growth bias (with 31% of its portfolio in technology stocks and a further 20% in biotech and healthcare at end-October), meaning it is also arguably the most vulnerable to a sustained market rotation in favour of more value and cyclical areas. TRG has roughly double MTE’s exposure to industrials (at 37.9% versus 20.0%) and financials (13.4% versus 7.0%). MTE has 32.0% of its portfolio in highly valued Sweden, whereas TRG has just 10.5%.

The second largest trust in the sector, TRG has the lowest ongoing charges, although it is the only one of the peers to carry a performance fee. In spite of its strong performance record, the trust currently trades on the second widest discount to NAV, 13.7pp wider than MTE’s 1.1% premium. Gearing at 10% is the highest in the group, well above the 4% average. TRG’s dividend yield is the highest of the three funds with a ‘natural’ yield; European Assets Trust’s high distribution policy (paying out 6% of NAV each year) means dividends are largely funded out of capital.

Although it invests principally for capital growth, TRG has had a long record of rewarding its shareholders through steadily growing regular dividends, which have been paid twice yearly since FY18. For FY21, an interim dividend of 8.2p and a final dividend of 16.8p have been declared, bringing the total to 25.0p, a 13.6% increase on the FY20 dividend (which was held at the same level as FY19). Prior to FY20, dividends had been well covered by portfolio income (1.3x in FY19), but the impact of the COVID-19 pandemic on corporate profitability and cash flows caused a dramatic dip in revenues in FY20, leading to the 22.0p total dividend for the year (unchanged on FY19) being only c 0.5x covered, with the remainder funded from TRG’s reserves.

The dividend payment schedules of continental European companies mean TRG’s income receipts are massively weighted to the second half of its financial year (1 January to 30 June). This meant a large (c 63% y-o-y) drop in portfolio dividends in H220, a period that included the initial ‘panic’ phase of the pandemic, when many companies suspended payouts in light of the uncertain outlook. However, FY21 has seen a significant recovery, with net revenue returns per share almost comparable with those of FY19, at 1.36p in H121 and 19.37p in H221 (more than 2.5x the 7.61p seen in H220), compared with 1.39p in H119 and 22.69p in H219. The FY21 total dividend of 25.0p per share was thus c 0.8x covered by the 20.73p per share revenue return, a significant improvement on FY20, with the prospect (although not the guarantee) of a return to a fully covered dividend in FY22.

Based on the current share price and the last two dividends, TRG has a dividend yield of 1.8%. After accounting for the FY21 final dividend (paid after the period end), but excluding any dividend receipts in H122 to date, TRG has revenue reserves of 29.5p per share, sufficient to sustain annual dividends at the FY21 level for around 14 months. The regular dividend (excluding specials) has grown at a compound annual rate of 22.7% over the five years to end-FY21.

At 1 December 2021, TRG’s shares traded at a 12.6% discount to cum-income NAV. While this is broadly in line with both short- and longer-term averages (11.6%, 13.0%, 10.9% and 12.7% respectively over one, three, five and 10 years), it is arguably wider than it should be given the trust’s strong recent performance. As can be seen in Exhibit 12, there was a period in late 2017 and early 2018 during which the shares traded at a small premium on the back of a 54.0% NAV total return in FY17, well below the 63.5% seen in FY21. While we acknowledge that the COVID-19 pandemic and associated difficulties such as the supply squeeze and higher inflation present a different investment landscape compared with 2017, we still believe TRG’s persistent double-digit discount is largely unwarranted given its strong long-term performance history. The board has taken steps to address this through the developments discussed on page 2.

While the board retains the authority to repurchase up to 14.99% of shares or allot shares up to the equivalent of 5% of the share capital, in order to manage a discount or a premium, in practice these powers are used sparingly, and there have been no repurchases since the summer of 2016. As shown in Exhibit 13, there was a limited amount of share issuance (c £5m) in FY18 to meet excess demand while the shares were trading at a premium.

Launched in 1990, TRG invests for long-term capital growth in a diversified portfolio of smaller European (ex-UK) companies that its managers believe are good value. The investment team at Janus Henderson Investors – lead manager (since 2011) Ollie Beckett, assisted by deputy Rory Stokes and analyst Julia Scheufler – employs an unconstrained, bottom-up approach to portfolio construction. The fund is biased towards the smaller end of the small-cap universe, with c 66% of TRG’s assets (at 30 September 2021) invested in companies with a market capitalisation below £1bn. Smaller companies may carry a higher risk of failure and can be illiquid, so TRG’s managers prefer to mitigate stock-specific risk by holding a relatively long list of stocks (c 120–150). There is a maximum individual position size of 7%, although in practice few holdings exceed 2% of the total. While the trust is permitted to hold unquoted investments (prior board approval is required), it currently has no such positions. TRG measures its performance against the EMIX Smaller Europe ex-UK Index in sterling terms (although this will change to the MSCI Europe ex-UK Small Cap Index from 1 July 2022) and is a member of the AIC’s European Smaller Companies sector.

While TRG’s main aim is to achieve capital growth, it also has a long record of year-on-year dividend growth and since FY18 has paid an interim as well as a final dividend to spread income more evenly through the year.

In order to achieve their aim of capturing the capital growth potential of small- to mid-cap European companies, TRG’s managers invest in securities that they believe to be mispriced relative to long-term fundamentals. The trust’s investment universe covers c 2,000 stocks across Europe with a market capitalisation below €4bn, from which Beckett, Stokes and Scheufler build a diversified portfolio of c 120–150 stocks. Using a range of quantitative screens, the team filters the opportunity set for attractive but undervalued companies. By undertaking hundreds of company meetings each year, they aim to assess the durability of business models, quality of management, drivers of growth and catalysts for revaluation. They also take account of in-house and external company research. For each potential investee company, the team builds financial models, using different valuation metrics to gain an understanding of the relationship between a firm’s growth potential and its current valuation. While they have a definite focus on mispriced securities, the managers stress that this ‘value’ approach does not mean they eschew ‘growth’ stocks. ‘We will buy growth, but only at a reasonable price’, says Beckett. The portfolio is built on a bottom-up basis, with no constraints on country or sector weighting, and position sizes are based on the managers’ degree of conviction, although they rarely exceed c 2%, given the focus on diversification.

Beckett, Stokes and Scheufler view their investment universe in terms of a company lifecycle with four stages. The managers comment that the majority of investors tend to concentrate their efforts in the middle two segments, meaning they could be missing out on attractive opportunities.

Portfolio turnover averages c 40–60% a year (41.9% of average net assets in FY21, down from 56.2% in FY20 and 57.6% in FY19), implying a holding period of around 1.5 to 2.5 years, although many companies are held for much longer than this.

Beckett and the team also run Janus Henderson’s open-ended pan-European smaller companies fund, and the manager says having a client base that includes continental European (and particularly Scandinavian) institutional investors means an awareness of ESG issues has long been part of the team’s investment approach.

TRG’s approach to ESG can be summed up as follows:

Beckett says European small-cap is at the forefront of sustainability almost by default, with many of TRG’s portfolio companies involved in areas associated with energy transition – which aligns with the United Nations’ Sustainable Development Goal (SDG) of ‘affordable and clean energy’ – as well as significant exposure to other SDGs such as good health and wellbeing, and sustainable cities and communities. However, smaller companies (by simple virtue of being more occupied in running their businesses) tend to be less focused on trumpeting their ESG credentials than larger firms with more marketing muscle, despite those ESG credentials often being more genuine and less ‘greenwashing’. Hence, Beckett describes TRG’s investment portfolio as being ‘laden with hidden ESG’, which could bear fruit in terms of a valuation premium once investors are made more aware of how these companies are helping to tackle social and environmental issues.

You can read TRG’s ESG policy (as published on the AIC website) in full here.

TRG is permitted to gear up to 30% of net assets, although its normal working range is 0–15%. It may also hold up to 20% in cash and/or fixed income. The trust has a £160m multicurrency overdraft facility with HSBC Bank (up from £100m in FY20), which represents available gearing of c 19% based on the current NAV. At end-FY21 (30 June 2021), £89.1m of the overdraft was drawn, a large increase from £48.3m at end-FY20, although given the c 60% rise in NAV during FY21, the percentage level of gearing remained relatively steady, at 10% versus 9% at the start of the year. At 31 October 2021, TRG’s net gearing stood at 10%, up from c 4–5% at points earlier in the summer when Beckett was ‘feeling a bit nervous’ on the outlook for markets.

Although it already had by some distance the lowest ongoing charges (excluding performance fees) in its peer group, TRG has reduced its base management fee further with effect from 1 October 2021, to 0.55% of net assets (from 0.60%) up to £800m and 0.45% thereafter. Previously, the lower fee tier (0.50%) kicked in above £500m. Based on 1 December net assets of £802.6m, we calculate the new fee basis would result in a 0.7% increase in management fees paid. (This is a rough calculation only, given the actual fees are calculated and paid quarterly.) The benefits of the reduction will accrue more if TRG’s net assets rise further above the £800m mark (note the net assets figure was c £830m in mid-November, which would have resulted in a 2.5% reduction in management fees versus FY21). The base ongoing charge at end-FY21 was 0.71% (FY20: 0.72%). We see good potential for this to fall below 0.70% under the new management fee structure.

Janus Henderson Investors may also be paid a performance fee (15% of excess performance, subject to a cap on total fees at 2.0% of net assets at the end of the period) if TRG’s NAV total return outperforms the benchmark EMIX Smaller Europe exUK Index by more than 1.0% on a rolling three-year basis. In FY21, a performance fee of just over £4.5m was paid; including this and based on average net assets, we calculate annualised ongoing charges including the performance fee to be 1.35%. No performance fee was paid in respect of FY20 or FY19. With effect from the beginning of FY23 (1 July 2022), the new benchmark index (MSCI Europe ex-UK Small Cap) will be adopted, and the performance fee calculation (which in other respects will be unchanged) will be based on outperformance of this index from this date.

TRG is a conventional investment trust with one class of share. At 1 December 2021, there were 50.1m ordinary shares in issue, a level unchanged since November 2017. Following approval of the proposed eight-for-one share split at the FY21 AGM on 29 November, this will rise to 400.9m with effect from 13 December 2021. As shown in Exhibit 14, TRG has a significant level of retail investor ownership, with three of the top four shareholders (accounting for 26.5% of the share base) being direct-to-consumer platforms. However, the largest shareholder, with 14.0% of shares outstanding, is currently Allspring Global Investments, the newly renamed Wells Capital Management, whose shareholding has increased from c 5.5% of the total at the start of 2021. Together with City of London IM and Lazard, this amounts to a significant 24.1% representation from more discount-focused institutions. The balance of the top shareholders (those holding at least 2.5% of TRG’s equity) is made up of traditional wealth managers Investec, Tilney Smith & Williamson and Rathbones. There is a reasonable level of trading liquidity in the shares (Exhibit 15), with an average of 63,100 shares changing hands every day over the 12 months to 1 December 2021; however, the board hopes the share split will increase liquidity as well as facilitating regular retail investment via platforms.

Having delayed his planned departure by a year in order to help steer the trust through the COVID-19 pandemic, Andrew Martin Smith retired from the board at the FY21 AGM on 29 November 2021. Alexander Mettenheimer has indicated his intention to step down at the FY22 AGM.

The directors’ fees, which are subject to an aggregate maximum of £250,000 and were last increased in FY19, will rise in FY22 to £44,000 for the chairman (+15.8%), £35,190 for the audit committee chairman (+3.5%) and £31,050 for the other directors (+3.5%), including the senior independent director (SID).