Fidelity European Values — Concentrating its portfolio and hedging its bets

Although European equity markets performed well in 2017, driven by strengthening corporate earnings growth, valuation multiples expanded relatively modestly. Higher earnings forecasts for 2018 have taken European market valuation multiples below the level of a year earlier and, although there is a similar picture for the US market, forward P/E multiples for European equities remain at a discount of c 20% to US equities. Exhibit 2 (left-hand chart) shows that, although it is still above its 13.2x five-year average, the Datastream Europe market forward P/E multiple has declined from 15.1x to 13.5x over the last three years. Over this period, the Datastream US market forward P/E multiple has only declined from 17.6x to 16.9x, making European equities appear more attractive on valuation grounds. The positive outlook for European corporate earnings growth is supported by the European economic sentiment indicator, which has risen steadily since August 2016 and is approaching its 30-year peak level, as illustrated in Exhibit 2 (right-hand chart).

In our view, attractive relative valuations and robust corporate earnings prospects, alongside improving global economic growth, create a positive outlook for European equities in 2018, but there are a number of geopolitical risks that could negatively affect markets. Inflation rising faster than anticipated, leading to a synchronised tightening of monetary policy by central banks, could see the valuation support of low bond yields removed at the same time as liquidity is withdrawn from markets. This would likely weigh on equity market performance and could lead to slowing economic growth, which would put further downward pressure on equity valuations.

Launched in 1991, FEV is an LSE-listed investment trust that invests in a portfolio of primarily continental European equities, aiming to outperform the FTSE World Europe ex-UK index over the longer term. Subject to shareholder approval at the May 2018 AGM, the board has proposed to amend the stated investment objective to achieving long-term growth in both capital and income, rather than just capital growth. This change is to acknowledge the manager’s attention to dividend income as well as capital growth and does not imply any change in investment approach, which focuses on a company’s ability to grow its dividend sustainably.

A bottom-up approach to portfolio construction is adopted, with no target sector and geographic allocations, although the manager aims to keep sector exposures within five percentage points of the benchmark index. No more than 10% of gross assets may be invested in a single company, while up to 20% of the portfolio in aggregate may be invested in companies outside the benchmark (including UK-listed companies) and up to 10% may be invested in unlisted securities. Derivatives are used to enhance investment returns and hedge market risk, with CFDs used to add gearing as well as to take short positions. Gearing is permitted up to 30% of net assets (although held below 15% since 2011), while there is a 10% restriction on gross short exposure.

FEV’s portfolio has been managed by Sam Morse since January 2011. He has more than 26 years’ investment experience and also manages the open-ended Fidelity European Fund.

While Sam Morse retains a very cautious view of the broader European market outlook, holding the belief that rising bond yields could have a particularly negative effect on equities, he intends to remain fully invested and has a positive overall gearing to the market. Having largely refrained from taking short positions since FEV’s investment policy was amended at the end of 2014, Morse took advantage of market strength in August 2017 to add 10 individual stock short positions to the portfolio. These were all structural short positions, without specific catalysts, and an equivalent weighting in Euro Stoxx 50 futures was purchased to keep net gearing at its previous, modestly positive level. The short positions are not disclosed, but Morse indicates that they have a bias to industrial cyclical stocks. He says that two of the short positions have been closed at a slight profit but, in aggregate, the short exposure has made a marginally negative contribution to performance.

Morse highlights that stock selection was the key driver of FEV’s outperformance in 2017, with the strongest contribution from the financial sector, where bank holdings ABN Amro, Intesa Sanpaolo and KBC delivered strong returns. He notes that the star performer in FEV’s portfolio, Société de Bains de Mer, almost doubled in value after the State of Monaco, its majority owner, bought out a large shareholder, followed by reports that its two major property redevelopments were progressing on time and on budget. He also flags the positive contribution from FEV’s overweight in technology, with strong returns from its holdings in ASML, Amadeus IT Group, SAP and Dassault Systèmes.

Morse observes that healthcare was the weakest sector in 2017, with Sanofi and Roche performing poorly due to the weaker US dollar and continued price pressures in all regions, while Novo Nordisk rebounded from a disappointing 2016, helped by the approval of its new diabetes drug Ozempic. Among detractors, he flags catering and concessions business Elior, which saw its shares fall on disappointing guidance for 2018 shortly after the CEO resigned, and led him to exit the position after the year-end. In H217, Morse sold Spanish natural gas network company, Enagas, French commercial property investment company Unibail-Rodamco, and Luxembourg communications satellite operator SES, all due to weakening fundamentals reducing dividend growth prospects. In 2018, he invested c 1% of the portfolio in a previously held stock, Italian toll road operator Atlantia, when share price weakness around the time of the Italian elections provided a buying opportunity.

The manager seeks to invest in companies that his analysis suggests are capable of growing their dividends sustainably over a period of three to five years. This approach is based on the belief that companies consistently growing their dividends tend to outperform over longer time periods. Three core investment principles define the investment approach:

The manager draws on Fidelity’s team of pan-European analysts in assessing whether a stock meets the investment criteria, and strong emphasis is placed on meeting company management.

To be considered for inclusion in the portfolio, companies need to display positive fundamental characteristics such as structural growth potential, disciplined capital allocation and a proven business model. Strong cash flow generation is viewed as a positive indicator of dividend growth prospects, and a robust balance sheet gives confidence in a company’s ability to sustain dividend payments while also investing for growth. The intrinsic value of potential investee companies is assessed, with investments only made when companies are trading at a discount to this valuation. The resulting portfolio is relatively concentrated, typically comprising 50-60 holdings.

FEV’s portfolio concentration increased in 2017, with the proceeds from stock sales mainly recycled into existing holdings and the number of portfolio holdings reduced from 57 to 49 (plus eight short positions). Since the year-end, Elior has been sold and Atlantia added, leaving the number of portfolio holdings unchanged at 49 at end-February 2018. Although the overall portfolio is more concentrated, exposure is more evenly spread, with the top 10 holdings representing 36.9% of the portfolio at end-February 2018 similar to 36.5% a year earlier. Exposure has become more concentrated in large-caps over the year; stocks with less than £10bn market cap fell from c 28% to c 21% of the portfolio (see Exhibit 1). At end-February 2018, single-stock short positions equated to c 4.0% of net assets, hedged by Euro Stoxx 50 index futures, representing 6.7% of net assets.

As shown in Exhibit 3, the portfolio remains well diversified by sector and geography at end-February 2018, with the balance of exposures broadly similar to a year earlier. The most significant sector changes are an increase in technology and decreases in consumer goods and consumer services. FEV’s largest overweight exposure is technology, followed by healthcare and industrials, while the most significant underweights are consumer goods and financials. The greatest changes by geography compared with a year earlier are a decrease in exposure to Switzerland and an increase in exposure to the Netherlands. The UK and France are the most significant overweight exposures, while Germany is the largest underweight.

As shown in Exhibit 4, FEV’s NAV total return was in line with its benchmark FTSE World Europe ex-UK index over one year to end-March 2018, while its share price total return significantly outperformed the benchmark. NAV performance broadly illustrates FEV’s tendency to outperform during periods of market weakness due to its relatively defensive positioning, which results from the manager’s investment process favouring stocks with a lower risk profile. As shown in Exhibit 5, FEV’s NAV total return is ahead of its benchmark over 10 years, but below the benchmark over three and five years. However, it has outperformed the MSCI Europe and FTSE All-Share indices over one, three, five and 10 years. As illustrated in Exhibit 6, FEV largely recovered the underperformance that occurred between August 2016 and March 2017, a period of market strength, although it lost some ground in the market weakness towards the end of March 2018.

As illustrated in Exhibit 7, after touching a three-year wide point of 17.3% in early July 2016, shortly after the UK’s EU referendum, FEV’s share price discount to NAV (including income) followed a narrowing trend through to April 2017, since when it has moved in a relatively narrow range between 6% and 11%. FEV’s current 9.6% discount is towards the wider end of this range and is slightly wider than its 8.6% and 8.9% averages over one and three years.

FEV has 415.2m ordinary shares in issue, unchanged since March 2017. The board has authority to repurchase up to 14.99% and allot up to 5% of FEV’s issued share capital, but buybacks have been modest since 2014 (see Exhibit 1). FEV’s normal policy is to employ a low level of gearing via CFDs to enhance investment returns. At end-February 2018, gross market gearing was 11.9%, including c 4.0% in individual stock short positions, which are balanced by an equivalent weighting in Euro Stoxx 50 index futures, while net gearing was 3.8%.

FEV has paid a flat annual management fee of 0.85% of net assets since 2007, but is introducing a tiered fee structure from 1 April 2018, with a lower 0.75% payable on net assets over £400m. No performance fee has been payable since 2014. FY17’s ongoing charge of 0.95% was lower than FY16’s 0.99%, helped by share plan expenses no longer being incurred as well as lower legal and professional fees, along with an 18% rise in net assets. The reduced management fees should see FEV’s ongoing charge decline to c 0.90% in FY19, when the lower fee has a full-year effect.

Consistent with FEV’s revised investment objective, with effect from FY18, management fees and finance costs will be charged 75% to capital and 25% to revenue, reflecting the historical balance of capital and revenue contributions to total return. Previously, these costs have been charged in their entirety to revenue. This change will not affect total returns, but will raise the proportion of revenue returns in future years, which should translate into a higher minimum level of dividend payouts.

FEV is subject to a two-yearly continuation vote, with the next vote due at the 2019 AGM.

There has been no explicit income objective historically, but the manager’s investment focus on companies capable of growing their dividend has seen FEV’s dividend payments rise over time (see Exhibit 1). The current proposal to change FEV’s investment objective to achieve long-term growth in both capital and income seeks to reflect this aspect of the investment approach. Although revenue earnings are largely distributed in full and significant reserves are not held to smooth dividend payments, FEV has increased its ordinary dividend in each of the last seven financial years and the current yield of 2.1% is only slightly lower than the sector average (see Exhibit 8). The FY17 recommended final dividend of 4.35p per share is 4.3% higher than the prior year, but the FY16 dividend saw a substantial 25.2% rise, and the dividend has grown by 12.2% pa over the last 10 years. The change in allocation of fees and expenses between revenue and capital accounts – noted above – should lead to a higher level of future dividend distributions than otherwise expected.

Exhibit 8 shows a comparison of the trusts in the AIC Europe sector, of which FEV is the largest. FEV’s NAV total return is ahead of the sector average over one year, but below the average over three, five and 10 years. We note that, while it is lower than the peer group averages over longer periods, FEV’s NAV total return has outperformed its benchmark over 10 years to end-March 2018 (see Exhibit 5). FEV’s 0.95% ongoing charge for FY17 is only slightly above the sector average, and the announced reduction in management fee from 1 April 2018 should see FEV’s ongoing charge decline to c 0.90% in FY19, when the lower fee has a full-year effect. Similar to most of its peers, FEV does not charge a performance fee. FEV’s discount is wider than average, while its net gearing and dividend yield are similar to the sector averages.

Since Fleur Meijs joined the board in September 2017, FEV has had six independent non-executive directors. Former PwC financial services partner Meijs is also a director of Invesco Asia Trust and investment manager Ruffer. After close to 11 years’ service, James Robinson will step down from the board at the 2018 AGM. He will be succeeded as senior independent director by Marion Sears (appointed January 2013), who is also a director of Aberdeen New Dawn Investment Trust. Chairman Vivian Bazalgette (appointed director December 2015, chairman May 2016) is a director of Brunner Investment Trust and Perpetual Income and Growth Investment Trust. The other directors are Robin Niblett (appointed January 2010) and Paul Yates (appointed March 2017), who is a director of Aberdeen Diversified Income and Growth Trust and The Merchants Trust.