BlackRock Greater Europe Investment Trust — Building on the record of outperformance

While European equities have delivered above average sterling-based returns since early 2016 (helped by sterling weakness), over the last five years Europe has underperformed the global market (Exhibit 2, LHS). Share prices have been supported by corporate earnings growth along with revaluation, due to ample available liquidity and low yields on competing asset classes such as developed market government bonds and cash. As a result, equity valuations are looking somewhat stretched versus history. Based on forward P/E multiples, European companies – while not as expensive as US equities – are trading at a 4% premium to their 10-year average.

In terms of economic growth, risks are arguably to the downside. In Europe, purchasing manager indices and economic sentiment indicators have started to decline, and there is uncertainty surrounding the ongoing Brexit negotiations. It is also important to note that more than half the revenues of European companies are generated outside the region, so firms are not immune to broader macro events such as the current dispute between the US and China. Taking the current macroeconomic environment and above-average equity valuations into account, investors may benefit from a more selective approach, seeking companies with sustainable growth characteristics, which are trading on reasonable valuations.

BRGE was launched in September 2004 and is co-managed by Stefan Gries (since June 2017 – focused on developed European markets) and Sam Vecht (since launch – focused on emerging markets). They both employ a bottom-up approach to stock selection, aiming to generate long-term capital growth. BRGE’s portfolio typically has c 35-45 holdings, across the market capitalisation spectrum, although the majority of positions are in companies larger than €10bn.

Investment guidelines include a maximum 25% of the risk allocation to be held in emerging Europe (currently less than 10%) and a limit of 5% in unquoted investments (together, these two exposures may not exceed 25%). Up to 15pp of emerging European exposure may be via funds, and direct investment in Russia is limited to 10% of total assets. Up to 20% of the portfolio may be held in bonds, although none are currently held. Derivatives are permitted for efficient portfolio management. The trust may gear up to 15% of NAV (at the time of drawdown) – net gearing was 1.9% at end-August 2018. BRGE is not benchmarked against a particular index, but the FTSE World Europe ex-UK index is used as a reference.

We met with Gries and discussed the current macroeconomic environment. He stressed that given BRGE’s bottom-up investment approach, his views on the macro background are formed on the basis of information that he and his team glean from meeting with, and analysing, European companies. His view is that although the consensus growth outlook has moderated compared with the beginning of this year, the eurozone economy is still expanding at a higher pace than the historical average.

In this environment, Gries says, it is very important to remain selective, as there are some areas of the market where earnings growth has moderated and estimate revisions are negative, such as autos and banks. The manager comments that earlier this year, investors had positive expectations regarding the prospects for European banks, based on a synchronised global economic expansion, which would lead to robust loan growth and higher interest rates in response to an uptick in inflation. Gries took a more conservative approach, given his belief that a lot of good news was already priced into bank stocks and that he did not expect positive earnings and cash flow estimate revisions due to higher inflation/interest rates. As a result, BRGE has a large underweight exposure to banks compared with the reference index, which has proved to be the correct decision, as the sector has significantly underperformed the broader European stock market so far in 2018. The manager says that this positioning is an example of BRGE’s diligent stock selection approach and that he ‘does not buy in to macro narratives’. He says he would have been unable to sit in front of the trust’s board and say with confidence that the banks were mispriced, and would be able to surprise positively in terms of earnings and cash flow generation.

While politics in Europe may periodically hit the headlines, Gries says that unless there is a broad-based change in the growth outlook, a change in the tax regime or a different regulatory environment, there tends to be very little effect at the corporate level from political news. However, negative headlines do have an impact on asset allocation. This is evident so far this year in negative fund flows from Europe, which may also be a result of moderating global growth, given that c 60% of the revenues of European companies are generated outside the region. As a result, due to a lack of appetite for European equities, despite better corporate earnings growth, the manager says that the stock market has failed to make much headway, in local currency terms, over the last three years.

Gries and his team seek companies that operate in niche businesses with structural end-market demand, which offers potential pricing power. These tend to be Europe-listed companies with attractive international businesses, which have favourable earnings and cash flow growth prospects over the next one to three years. Overall, the manager believes that the growth environment is favourable; while Europe is slowing somewhat, data from the US remains strong and the Chinese government is managing its economy to ensure that it continues to grow. However, there are risks to global trade as a result of the US’s protectionist policies. Gries says that until recently, volume data from freight forwarding companies have remained robust. He will be carefully monitoring the commentary from these companies in their Q318 earnings reports to see if a recent slowdown in rolling three-month volumes was just a blip, or the start of a longer-term negative trend.

Co-managers Gries (developed European markets) and Vecht (emerging markets) are able to draw on the broad resources of BlackRock’s investment teams to construct a concentrated portfolio of c 35-45 European equities, which are selected from an investible universe of c 2,000 companies. Developed market equities make up the lion’s share of BRGE’s exposure. Gries invests on a bottom-up basis, based on four primary criteria:

The manager and his team look for companies where these characteristics are not reflected in their current share prices, and there is potential for positive cash flow and earnings estimate revisions. The team works on a collaborative basis, undertaking thorough fundamental research, and company meetings are a key part of the investment process. A research template, which includes financial modelling, is constructed for potential investee companies.

However, Gries says that it is important to ‘keep the plate spinning’ – the research templates and company meetings are viewed as just the start of the journey, and the team must continue revisiting the same ideas to garner more information. He acknowledges that sometimes the investment case proves to be less strong than originally envisaged. The manager cites the former BRGE holding in Switzerland-based luxury goods company Richemont, where he became concerned about a series of senior management changes, underperformance in some of its key brands and the questionable re-acquisition at a high valuation of online shopping portal Net-a-Porter, following its merger with Yoox. Other reasons for a position to be sold are if the investment case has played out, meaning little further share price appreciation is expected, or if a superior investment opportunity is identified elsewhere. In terms of oversight, BlackRock employs a proprietary risk management system, both to mitigate risk, and help to maximise shareholder returns.

Following the appointment of Gries as co-manager in June 2017, the investment process has essentially stayed the same. However, he has tweaked the approach, which judging from the trust’s performance since then (see pages 7 and 8) has proved successful. Gries has strengthened the investment philosophy; moved to higher-conviction positions and increased the portfolio’s active share (a measure of how a portfolio deviates from an index, with 0% representing full index replication and 100% representing no commonality); delivered excess returns from the European investment team more effectively; and opportunistically used the investment trust toolkit, which includes gearing.

At end-August 2018, BRGE’s top 10 positions made up 41.3% of the portfolio, which was an increase in concentration compared with 38.8% a year earlier; four positions were common to both periods. In terms of sector exposure (Exhibit 3), over the last 12 months, the largest increases were in industrials (+5.6pp) and healthcare (+4.8pp), with the largest decrease (-6.9pp) in consumer services. The unconstrained investment approach is illustrated by the large divergences compared with the reference index, such as the more than double weight in industrials and a half weighting in the financial sector, which makes up more than a fifth of the FTSE World Europe ex-UK index.

Gries highlights the holding in ASML as an example of a company with a strong brand and pricing power. It has an 86% global market share in the lithography semiconductor manufacturing equipment market, serving the leading chip manufacturers such as Intel, Samsung and Taiwan Semiconductor Manufacturing. ASML is rolling out its EUV platform, which enables semiconductor manufacturers to reduce chip size and increase memory capacity. It is also developing a successor product, and two large clients have paid €200m each for the option to test a 2021/22 prototype that will be rolled out in 2023/24. Gries believes that no other company would be able to charge this amount of money for a prototype with a five- to six-year production lead time.

The manager highlights the importance of patience and waiting for opportunities. A recent example is the new holding in luxury auto manufacturer Ferrari. The team had been monitoring the company for some time, and took the opportunity to initiate a position when its stock price fell in July 2018 following the death of its well-respected CEO Sergio Marchionne. Gries says that mass-market auto manufacturers only generate c 5-6% EBIT margins, due to their lack of pricing power. However, Ferrari has 23% EBIT margins, which he envisages can expand over the next two to three years. Earnings visibility is high as the company has a two-year customer waiting list. It has established strong brand loyalty, with c 60% of all new Ferraris purchased by existing owners, of whom more than 40% have more than one of the company’s vehicles. Historically, Ferrari has not put through regular price increases, but this is changing and customers are not price-sensitive. There is also high demand for its limited editions; 500 supercars are sold by invitation at price tags in excess of €1.5m, despite having similar underlying technology to the regular models. The company recently hosted a capital markets day, which was well-received by investors, and is working to monetise its brand outside of autos. The manager believes that Ferrari has the potential to be a multi-year holding in BRGE’s portfolio.

Another new holding in the portfolio is FinecoBank, an Italian multi-channel bank offering banking, credit, trading and investment services from a single account. Its transaction and consulting services and platforms are developed in-house using proprietary technology. This innovative approach means that the bank is taking share from the more traditional banks, which offer lower-quality products and are encumbered by their legacy IT systems. Gries initiated the position in FinecoBank during a period of share price weakness due to negative political headlines in Italy.

A couple of relatively recent disposals in the fund are legacy positions (dating back to the prior manager). Renault has not been delivering strong results, and Gries had question marks over the quality of the management team and the company’s return profile and growth outlook. Bayer has experienced weakness in some of its core businesses, such as consumer and agricultural products, and the manager is concerned about the ramifications of the large Monsanto acquisition. In both cases, Gries believes that there are better uses for BRGE’s capital elsewhere.

Emerging Europe is currently less than 10% of BRGE’s exposure, which compares to a historical range of c 5-15%. Profits were taken in Russian energy companies Novatek and Rosneft, as their share prices had performed well and their valuations normalised. The position in Israeli generic drug manufacturer Teva Pharmaceutical Industries was sold. It was purchased following a significant pullback in the stock, and profits were taken following a big bounce in the share price in a short space of time. The manager says that this is an example of the potential share price volatility in emerging markets. BRGE once again has a position in Russian bank Sberbank, whose share price retreated following headlines about US sanctions. Gries and Vecht cite the company’s strong fundamental outlook; it has a 50% share of the Russian mortgage market, in a country where home ownership is low and housing is becoming more affordable due to lower interest rates. Sberbank generates a much higher return on equity than the traditional European banks, and is trading at an attractive valuation – a forward P/E multiple of c 5x, while offering a c 6% dividend yield. While Vecht and his emerging markets team have considered the impact of US sanctions, they believe that the effect on Sberbank’s operations will be limited. The position was built up throughout the summer, and the company’s share price is now starting to recover.

Over the last 12 months, BRGE’s NAV and share price total returns of 11.6% and 11.0% respectively are meaningfully ahead of the reference index’s 2.0% total return. The manager is particularly pleased that the majority of this outperformance is due to stock selection rather than sector allocation, as he says it validates the trust’s robust investment process. During the period, the best contributors to performance included speciality chemical company Lonza, aeroplane engine manufacturer Safran, and luxury goods firm Kering. Gries says that in an environment where predictable growth is relatively scarce, these companies have options for growth, and have over-delivered on earnings and cash flow generation. He says that the corporate growth profile in Europe has changed; in 2000, around half of the listed companies were able to grow organically at c 7-8% pa, but this figure is now down to about one in nine.

The position in Danske Bank, which is facing allegations of money laundering through its Estonian operation, has detracted from returns. Gries says that the company’s underlying business is strong, its balance sheet is robust enough to support a fine and, at the current share price, the company is looking particularly interesting. Another detractor was Telenet Group, which was underperforming the broader stock market. The manager and his team undertook further research on the company and concluded that the Belgium telecom sector has changed, and is now more competitive. As a result, the Telenet position was sold.

BRGE’s relative performance is shown in Exhibit 5. It has outperformed the reference index over one, three, five and 10 years, in both NAV and share price terms. It is also interesting to note the trust’s superior performance compared to the UK stock market, outperforming over all of the periods shown, with the exception of the last month.

Exhibit 6 shows BRGE’s relative performance over the last three years. It clearly shows how well the trust has performed since Gries took over as lead manager in June 2017. Since then, BRGE has outperformed the reference index by c 12pp.

Historically, BRGE’s shares trade in a pretty narrow band versus its NAV, and its current 4.4% share price discount to cum-income NAV is broadly in line with the averages of the last one, three, five and 10 years (range of 4.0% to 4.6%).

The board actively manages the discount via periodic repurchases and discretionary semi-annual tender offers for up to 20% of shares outstanding. Results of the last tender offer were released on 1 June 2018 – 2.3m ordinary shares were tendered (2.6% of shares in issue, excluding treasury shares) at 351.43p (the prevailing cum-income NAV minus 2% to cover costs). The board has announced that the calculation date for the next tender offer will be 30 November 2018.

BRGE is a conventional investment trust, with one class of share, following the final conversion of subscription shares in FY16. There are 86.5m ordinary shares in issue, and a further 23.9m are held in treasury. The trust has a £20m overdraft facility and may gear up to a maximum 15% of NAV at the time of drawdown. At end-August 2018, net gearing was 1.9%, which compares to a historical range of c 15% geared to c 10% net cash.

Since 1 September 2015, BlackRock has been paid an annual management fee of 0.85% of NAV, and no performance fee is payable. In FY17, ongoing charges were 1.10%, which was 3bp higher than 1.07% in FY16.

BRGE historically paid dividends once a year; however, since 2014, they have been paid twice, in May and December. The board adopts a progressive distribution policy, and the regular dividend has increased every year since the trust was launched in 2004. At end-H118, BRGE had £8.2m of distributable reserves, which is more than 1x the last annual distribution and may be used to smooth dividend payments in years of lower revenue generation. Based on its current share price, BRGE offers a 1.7% dividend yield.

BRGE is a member of the AIC Europe sector, a relatively small peer group of eight funds. Its NAV total returns are above average over one and three years, ranking third and second, respectively, while lagging over five and 10 years. BRGE’s discount is narrower than average, its level of gearing is modestly lower than the peer group average, and it has a below-average dividend yield. While the trust has the highest ongoing charge in the peer group, the range for the whole sector (with the exception of European Investment Trust) is narrow, and in common with four other peers, BRGE does not charge a performance fee.

There are four independent, non-executive directors on BRGE’s board. The chairman is Eric Sanderson, who was appointed as a director in April 2013 and assumed his current role in November 2016. The other three directors are Davina Curling (appointed in December 2011), Peter Baxter (April 2015) and Paola Subacchi (July 2017).