BlackRock Greater Europe Investment Trust — Update 10 November 2016

Exhibit 2 (left-hand side) shows the performance of the continental European stock market in sterling terms over the last 10 years in absolute terms and relative to the world market. Europe has been relatively weaker since the end of the global financial crisis; a contributing factor has been slower economic growth versus the US (>50% of the World index). However, in its latest World Economic Outlook, the International Monetary Fund increased its forecasts for European economic growth by 0.1pp in both 2016 and 2017, while reducing US forecasts by 0.6pp and 0.3pp for 2016 and 2017 respectively. European forecast growth for 2016 is now higher than in the US, although 2017 estimates remain lower. Looking at valuations in Exhibit 2 (right-hand side), while above average, Europe ex-UK looks more attractive than both the UK and US markets on a forward P/E basis, trading at a 15% premium to its 10-year average versus 21% and 17% respectively. On a price-to-book basis, Europe ex-UK looks more attractive than the UK, US and world markets.

BRGE was launched in September 2004, aiming to generate long-term capital growth from a portfolio of European equities. Investments are made across the market cap spectrum, although the majority of holdings are above €5bn; the portfolio comprises c 30-70 holdings (typically 45-65). Manager Vincent Devlin (a senior manager in the European equity team) selects developed European equities, while Sam Vecht (head of the emerging markets specialist equity team) suggests investments in developing Europe – up to a maximum of 25% is permitted, although in practice exposure tends to be in a range of 5-8% (currently 4.8%). Up to a maximum 10% may be invested in Russia (currently 3.4%), up to 20% in debt instruments and up to 5% in unquoted securities (both currently 0%); gearing of up to 15% of NAV is permitted. There is an active discount control mechanism in place; the board has discretion to conduct a semi-annual tender of up to 20% of shares outstanding, along with regular share repurchases.

Manager Vincent Devlin suggests that the environment of low economic growth and interest rates in continental Europe will continue and, unlike in the US, there is no sign of wage inflation. Although recovery is muted, the improvement seen over the last two years remains intact and the manager is still finding attractive investment opportunities. The political environment is constantly changing and in recent years there has been a rise in ‘non-traditional’ parties. This may make it difficult to pass fiscal policy in the coming years as stimulus shifts from monetary to fiscal accommodation. There will also be potential impacts from Brexit; the manager sold BRGE’s position in Ryanair on the back of an uncertain outlook. Since 2012, in developed markets ex-US there has been a fiscal drag as a result of austerity. However, the fiscal contribution of developed markets to world GDP has now turned positive, which is beneficial for construction and materials stocks such as French infrastructure and construction company Vinci and Swiss sanitary ware manufacturer Geberit, both of which are represented in the BRGE portfolio.

Devlin comments that in aggregate, there is a lack of earnings growth in 2016, and some sectors have seen estimate downgrades, such as banks and commodities. As a result, he believes that earnings estimates are now realistic. He suggests that companies which are able to grow are trading on high multiples due to their scarcity value and that valuations in aggregate are high versus history. Asset allocators are favouring equities in a search for yield and the valuations of fixed-income securities are unattractive. In a low-growth, low interest rate environment, companies generating low single-digit earnings growth and yielding 3-4% are viewed as attractive and, while dividend growth of c 3% is modest, companies are not having to cut their dividends.

The manager highlights an important issue regarding investor sentiment towards continental European equities. Year to date, there have been massive outflows; to mid-October, there were 36 consecutive weeks of outflows totalling c $100bn, which is very unusual. Other areas of the market such as Japanese and emerging market equities and US and European credit are seeing inflows; a reversal in fund flows would be supportive for continental European equities.

BRGE adopts a flexible investment style, conducting disciplined fundamental research to identify inefficiencies in the equity market. The process is bottom-up, with a high awareness of the macro environment. The manager and the BlackRock European equity team seek to invest in companies that have sustainable cash flow generation, which should lead to capital appreciation and the payment of dividends. An initial screen of the investment universe highlights companies that are worthy of further investigation. This involves in-depth fundamental analysis, financial modelling, team discussion to challenge investment assumptions and company meetings, which form a key part of the investment process. Stocks are then given a rating between 1 (strong buy) and 5 (sell); the portfolio will typically comprise 20% 1-rated, 60% 2-rated and 20% 3-rated stocks. As the majority of companies in which BRGE invests have global operations, the manager needs to be aware of a broad range of issues including global interest rates and currencies. He is able to draw on the vast available resources at BlackRock to help him form his views. Risk management is a key part of the investment process; BlackRock uses a proprietary model to evaluate portfolio risk. For a more detailed discussion of the investment process, please see our March 2016 initiation report.

At end-September 2016, the top 10 positions accounted for 30.1% of BRGE’s portfolio; this was a modest decrease in concentration from 34.0% at end-September 2015. Two names were common to both periods. Versus the benchmark, the portfolio continues to be underweight mega-cap stocks, with the largest overweight exposure in companies with market caps between €2bn and €5bn.

Looking at sector exposure in Exhibit 3, over the last 12 months the largest increases in exposure are in consumer goods and industrials, while the largest decrease was in financials. In consumer goods, Pernod Ricard has been added to the portfolio. Spirits industry supply/demand is back in balance following a boom in Asia and subsequent destocking; this will lead to a better pricing environment and the US market is now growing as a result of higher advertising spending. In industrials, a position was initiated in Tenaris, which manufactures seamless pipes, some of which are used in shale oil and gas production. The stock was purchased at an attractive valuation following weakness in the oil price. Tenaris has a strong balance sheet and has been investing in client solutions; it is taking market share from its indebted French competitor, Vallourec. In financials, Intesa Sanpaolo and Helvetia were sold. Intesa Sanpaolo is a high-quality Italian bank with a strong balance sheet and a high dividend. However, the manager is concerned about the risk inherent in the whole Italian banking system. Helvetia is a Swiss multi-line insurance company. It purchased its competitor, National Suisse, which resulted in the generation of significant synergies; the manager considered that the benefits had been reflected in the prevailing share price.

Recent transactions in the BRGE portfolio include a switch from Heineken into Anheuser-Busch InBev (ABI) on valuation grounds. ABI’s recent acquisition of SABMiller should generate additional earnings growth from synergies. It is a major industry deal and will allow ABI to have better control over its pricing and products, while bringing economies of scale, better distribution and lower costs. InBev purchased Anheuser-Busch in 2008; the acquisition was very well integrated, illustrating ABI’s ability to deliver shareholder value following a major transaction. The SABMiller deal will increase ABI’s exposure to Africa, which is a less penetrated market. It has the lowest per-capita consumption, but is the highest-growth beer market in the world.

Within the healthcare sector, longstanding position Novo Nordisk was sold. Competitor Sanofi’s key diabetes drug has been removed from the approved drug lists of some healthcare providers on the basis of cost. Although this should provide a short-term boost to Novo, Devlin says it illustrates that drug purchasers are playing hardball, which is a risk to the company in the future, despite its premium products and strong pipeline. Drug pricing remains a hot topic in the US and there is a potential approval later in 2016 of a competing biosimilar product to Sanofi’s Lantus diabetes medication. The manager will reconsider his view on Novo’s stock in 2017, once there is greater clarity on drug pricing and the US election has passed. The company has a structural growth profile given the global rise in diabetes patients, both in developed economies and emerging markets, where people are adopting a more Western diet and lifestyle.

In the 12 months to 30 September, on a sector basis, the largest contributors to performance were consumer goods (+0.63pp) and industrials (+0.41pp), while the largest detractors were basic materials (-1.02pp) and consumer services (-0.93pp). On an individual stock basis, the largest contributors were positions in sportswear company Adidas (+1.55pp), which has accelerating sales growth, restructuring benefits and a new CEO; and Russian bank Sberbank (+0.90pp), which has a 50% share of the Russian retail deposit market. The largest detractors were Bank of Ireland
(-0.90pp), whose share price fell following the Brexit vote, given that 25% of profits are generated in the UK, and Italian asset manager Anima Holding (-0.82pp), where there have been question marks over its ability to gather assets from Italian bank distribution partners, given concerns about the strength of the Italian banking system.

Exhibit 4 shows absolute returns, which have been boosted over the last year by the weakness in sterling versus the euro. Exhibit 5 shows BRGE’s relative performance; its NAV total return has beaten the benchmark total return over one, three, five and 10 years. As a reference to UK-based investors, its NAV and share price total returns have outperformed the FTSE All-Share index over all periods shown. BRGE’s underperformance versus the FTSE World index is a result of the strong relative performance of US equities.

Exhibit 6 shows the performance of BRGE relative to the benchmark over the last 10 years. While there have been periods of underperformance, the overall trend is positive. BRGE’s NAV total return has outperformed the benchmark by an average c 1.9% pa over the period.

BRGE’s current share price discount to cum-income NAV of 5.5% compares to a range of a 2.2% premium to a 9.5% discount over the last 12 months. It is modestly wider than the averages of one, three, five and 10 years (range of 3.6% to 4.5%).

BRGE’s board actively manages the discount; it has the option to implement a semi-annual tender offer for up to 20% of shares outstanding, in addition to share repurchases between tenders, when this is considered to be in the interests of shareholders. The last tender offer was on 1 December 2015, when 1.19% of issued shares were tendered at a price of 250.56p. The board decided not to implement a tender offer in May 2016, given a narrow discount, the cost of the exercise and the low take-up of the previous offer. The next tender offer will be on 1 December 2016, based on the end-November fully diluted NAV minus a 2% discount.

BRGE is a conventional investment trust with one class of share; there are currently 102.0m ordinary shares in issue, plus a further 8.3m shares held in treasury. In FY16, BRGE issued 0.5m shares following the conversion of subscription shares; total proceeds were £1.3m. The final exercise date for the subscription shares was on 29 April 2016 – the subscription conversion price of 248p was above the prevailing share price in the offer period, hence the 20.0m outstanding subscription shares lapsed.

Since 1 September 2015, BlackRock has been paid an annual fee of 0.85% of net asset value and no performance fee; prior to this the annual fee was 0.70% of market value plus a performance fee of 15% of any outperformance versus the benchmark, over a rolling three-year period, up to a maximum of 1.15%. In FY16, ongoing charges were 1.07% versus 0.89% in the prior year. In FY15, the inclusion of a performance fee meant that total ongoing charges were 1.22%.

Gearing of up to 15% of NAV is permitted. BRGE has a £20m overdraft facility in place, repayable at any time, which is used when the manager has more buy than sell ideas, rather than taking a view on the direction of the stock market. At end-September 2016, net gearing was 1.4%.

Despite the focus on capital appreciation, BRGE adopts a progressive dividend policy. Dividends are currently paid twice a year in April and October; prior to 2014 payments were made annually. Ordinary dividends have increased every year since the trust’s inception in 2004. A final dividend of 3.65p per share for 2016 has been recommended; coupled with the interim dividend of 1.65p this means the annual dividend for FY16 is 6.1% higher than FY15. This is in line with the increase in revenue return. The FY16 dividend is 1.06x covered and the current dividend yield is 2.0%.

BRGE is one of eight trusts that comprise the AIC Europe sector. Its NAV total return is ahead of the peer group weighted average over one year, ranking fourth, but lags the averages over three, five and 10 years. In terms of risk-adjusted returns as measured by the Sharpe ratio, it is above average over one year and below over three years. BRGE has the narrowest discount in the sector. Its ongoing charge is modestly higher than the average and there is no performance fee. As befits BRGE’s focus on capital growth rather than income, its dividend yield is the equal third-lowest in the group.

There are four directors on the BRGE board; all are non-executive and independent of the manager. Chairman Carol Ferguson was appointed in June 2004. She will be stepping down as chairman at the next AGM, but will remain on the board as a non-executive director. Ferguson will be succeeded by Eric Sanderson, who was appointed to the board in April 2013. The other two directors and their dates of appointment are Davina Curling (December 2011) and Peter Baxter (April 2015). The board is in the process of seeking an additional director.