European Assets Trust — High income and improving performance

The European economy has been hit relatively hard by the COVID-19 pandemic. The euro-area economy contracted by an estimated 7.2% in 2020, according to the IMF, compared to a contraction of 4.9% in advanced economies as a whole. However, the region is forecast to rebound this year, with projected growth of 4.2% and a further 3.6% expansion in 2022 – a little stronger than the recovery the IMF forecasts for the advanced economies this year and next.

This more upbeat global economic outlook is due to some key developments at the end of last year: the arrival of several viable vaccines and additional, aggressive US stimulus measures from the new Biden administration. These events sparked gains in European and global stock markets and encouraged a significant rotation into value and cyclical stocks in all markets. Nonetheless, the disparity between value and growth stocks remains at its widest in at least a decade – in Europe, as elsewhere – and there is scope for this disparity to narrow further if confidence in the economic outlook continues to improve.

Despite recent gains, European equity markets remain attractively priced on both historical measures and compared to the world market (Exhibit 1). The MSCI Europe Index’s forward P/E ratio at end January 2021 was 17.6x, compared to the MSCI World Index’s forward P/E of 20.3x, and on a price-to-book valuation, Europe remains at lows vs the US not seen in several decades. Another key feature of European equity markets is that although small-cap European companies have outperformed the broader market recently (Exhibit 1), they are still trading near 20-year lows relative to large-cap companies, on both P/E and price-to-book (P/B) bases. These valuation metrics suggest that European equities offer value at current levels and that the European small-cap space may provide particularly appealing opportunities to invest in good, well-priced but overlooked businesses.

EAT’s portfolio has always had a quality, growth bias and managers Sam Cosh and Lucy Morris intend to maintain this bias. They stress that they have, in fact, used the opportunities created by the Q120 market turmoil to increase the quality characteristics of the portfolio, at attractive prices. As Exhibit 3 shows, EAT has a better return on equity and stronger growth and balance sheet characteristics than the index.

However, Cosh and Morris are mindful of the current disparity between growth and value stocks and they expect value and cyclical stocks to benefit as the current, nascent economic recovery gathers momentum over the course of 2021 and beyond. They acknowledge that their focus on quality and growth means that the portfolio would lag an aggressive value rally. To address this risk, the portfolio retains some balance, with exposure to three kinds of businesses: companies they believe are ‘great businesses’, such as Wizz Air, the budget airline, Marr, an Italian food company, and Coor, a Swedish commercial services company, that have yet to recover from last year’s economic shock; good-quality cyclicals such as Interpump, a world leader in the production of pumps and hydraulic components, Fluidra, a swimming pool company, and Norma, an industrial components manufacturer; and companies that will benefit from an eventual rise in interest rates, such as Avanza, a Swedish online broker, Storebrand, a Norwegian financial services company, and Ringkjoebing Landbobank and SpareBank. The managers believe this balance, combined with the majority of the portfolio’s holdings in enduring quality stocks, means EAT is well-placed to continue to benefit as Europe’s economic recovery gains pace.

In addition to the acquisitions mentioned above, the managers have sought greater exposure to companies benefiting from the accelerated pace of technological transformation triggered by the pandemic. Acquisitions related to this theme include Nordic Semiconductor, which has proved to be the portfolio’s top performer over the year to end December 2020 as its price has tripled on demand for chips. Cosh and Morris have also opened a position in Global Fashion Group, an online fashion retailer operating in emerging markets, where market penetration is low and there is potential for strong growth. The digitalisation of healthcare is another manifestation of this trend and to gain exposure, the managers have purchased Carasant, a small company focused on electronic patient records, an area set to grow rapidly as healthcare moves online. While many healthcare stocks are now expensive, potentially having benefited disproportionately from the crisis, the portfolio still has significant exposure to the sector, focusing on companies where the outlook is not just dependent on crisis-related demand. For example, the managers invested in German diagnostics business Stratec (now a top 10 holding), which is benefiting from the start of a new product cycle. More recent purchases have included ALTEN, a French provider of industrial R&D, with a good track record of organic growth, and Sligo, a market-leading Dutch food company. Sligo sells to the hospitality industry so 2020 was a challenging year, but the managers believe the company used the time well, to integrate some acquisitions and restructure its logistics and cost base. They expect the company to emerge from the pandemic stronger and capable of gaining market share.

The managers have also sold or pared some holdings where they believe pandemic-driven gains were fully priced in. As mentioned above, the healthcare sector did especially well during the early months of the pandemic and two of EAT’s holdings, DiaSorin, a medical equipment company that has developed a COVID-19 serology, and Tecan, a diagnostic company, were beneficiaries of this trend. Positions in these two businesses were initially reduced by 50%, then closed entirely in Q4, on the view that earnings would struggle to keep up with valuations. The managers also took profits on online broker Avanza, which had also performed strongly. Several poor performers were also sold, including Irish Continental Group, a ferry company, TGS NOPEC, a Norwegian energy equipment company, Lenzing, an Austrian chemicals company, and Aareal, a German regional bank.

EAT’s top 10 holdings list (Exhibit 2) features several industrial companies, including its top holding, Spanish glass bottle manufacturer Vidrala, along with Norma, a German industrial components company, and Marel, an Icelandic machinery producer. Industrials are also the portfolio’s largest sectoral exposure, representing 23.0% of the portfolio and end-January 2021 (Exhibit 3). The managers would like to hold more industrial names, but they are finding idea generation in the sector challenging, with many of the quality industrial businesses trading at excessive valuations. Consumer discretionary is the second largest sectoral position, representing 18.1% at end January, with positions including two top 10 holdings: German food home delivery service HelloFresh and Wizz Air. EAT’s second largest holding is in FlatexDEGIRO, a German online broker, and Gerresheimer, a pharmaceutical packaging company, is its third largest. This company performed well throughout the year, although it lagged the value rally in Q420. The managers believe it is well positioned to continue delivering strong operational performance, not least as a result of its large market position in the glass vial market, which is vital to the roll out of the coronavirus vaccine.

Portfolio turnover reached an annualised rate of around 48% during 2020. This unusually high level reflected portfolio activity in the first half of the year, when rare trading opportunities arose as the market sold off at the onset of the crisis. Turnover has since returned to more normal levels of around 20%. However, the managers stress that if market volatility increases, they intend to use it where possible to add more quality businesses that have so far been too highly priced.

Portfolio changes made since the onset of the pandemic are having a favourable impact on EAT’s performance. In the six months to end January, EAT made positive absolute gains, returning 24.4% in share price terms and 23.7% in net asset value (NAV) terms (Exhibit 6, RHS), and it slightly outperformed its benchmark, the EMIX Smaller Europe ex-UK index, which returned 22.2%. The trust’s longer-term performance has also been solid in absolute and relative terms. It has delivered outright gains over all periods shown in Exhibit 6, beyond one month, and although its performance has been mixed against its benchmark and the MSCI Europe ex-UK over one, three and five years, it has outperformed both indices over 10 years (Exhibit 7). It has also outperformed the UK market consistently, which illustrates the potential benefits for UK investors of diversification away from the UK market.

EAT’s returns over the 12 months to end-December 2020 have been driven exclusively by stock selection. The main contributors to performance during 2020 included Nordic Semiconductors, as mentioned above, and healthcare companies DiaSorin and Tecan Group (both of which were sold in Q420). Norma also added to returns, as did FlatexDEGIRO, a German broker that has benefited from the recent rise in retail investor activity. Fluidra, a Spanish pool company, has seen excellent results as property owners confined at home due to coronavirus restrictions have installed pools to improve their home environment. Fluidra is a global market leader in its field and has positioned itself to expand its market share following a recent merger with a US company. The contributions to performance from these and other holdings over the 12 months to end-December 2020 were only partially offset by the adverse performance impact of CANCOM, a German information technology services company, Marr and JustEat, a food delivery service. However, the managers believe that these three companies will eventually realise their potential, so these positions have been maintained. Other detractors such as TGS NOPEC, Irish Continental Group and Aareal have since been sold.

More recently, EAT’s performance was flat in NAV terms in January 2021. Its technology and e-commerce holdings were supportive – ASM International, a Dutch semiconductor equipment provider, Global Fashion Group and HelloFresh, all began 2021 well. However, these gains were offset by a decline in its position in Coor, the Swedish commercial services company, which was hurt by what the managers believe was an excessively adverse reaction to news of a large contract loss. Coor maintains that its contract pipeline is strong, and Cosh and Morris have opted to continue holding this position pending the release of the company’s full-year results.

EAT is a member of the AIC European Smaller Companies sector, which consists of four funds, shown in Exhibit 9. While all members of this sector target capital growth, EAT is the only trust committed to a high dividend distribution policy. Its performance ranks third over one year, which is an improvement on its fourth place ranking in August 2020. Its rankings of third over three years and fourth over five years are unchanged since August 2020. The trust’s dividend yield is significantly higher than any of its peers. This helps support its discount to cum-fair NAV, where it ranks second among its peers. EAT’s ongoing fees are the second lowest in its sector and like most of its peers, it does not pay a performance fee. Its net gearing is the highest among its peers.

EAT’s board is committed to a high dividend distribution policy, paying an annual dividend of 6% of NAV as at the end of the preceding financial year. This can be funded from both income and distributable reserves. The annual total dividend is declared in January each year. For FY21, the board announced an 8.00p per share payment, which represents a 14.0% increase on FY20. The first quarterly instalment of 2.00p per share was paid on 29 January 2021 and the remaining three quarterly instalments of 2.00p per share will be paid in April, July and October. Beginning in FY20, dividends have been paid in sterling, rather than euros, which had been the previous practice before the trust’s migration to the UK. At the current share price, EAT’s prospective dividend yield for FY21 is 6.7%, comfortably more than double the average of its peers.

The market turbulence triggered by the pandemic meant Q120 was a volatile time for EAT’s share price, as it was for most UK investment trusts. The share price discount to cum-income NAV widened sharply for a brief period in March 2020 (Exhibit 11) but has since returned to its short-term trading range around 10%. EAT’s shares are currently trading at a discount of 10.9%. However, this is relatively wide by historical standards, as the trust’s average discount has been 7.2% over three years, 5.1% over five years and 4.7% over 10 years.

EAT’s board is committed to managing the discount and has the authority to influence the demand and supply balance by share issuance and buybacks. However, share issuance has been very modest in recent years and the board has not conducted any buybacks in the past decade. The board believes that the migration of the trust to the UK in March 2019 has broadened its investor base, and this, combined with the high dividend pay-out policy, the April 2020 fee reduction and its recently improved performance, may help EAT’s discount narrow back towards its longer-term average over time.

EAT targets capital growth through investment in quoted small- and medium-sized European companies. Its benchmark is the EMIX European Smaller Companies ex-UK Index. The fund is managed by Sam Cosh (lead manager) and Lucy Morris, who believe that smaller companies are often under-researched and thus possibly also undervalued, with scope for potentially significant outperformance over time. They follow a systematic, bottom-up, patient investment approach, which results in a relatively concentrated yet diversified portfolio typically of 40–50 holdings.

The trust was launched in 1972 as a Dutch company and until March 2019, its shares were dual-listed on the Amsterdam and London stock exchanges. In March 2019 the board completed a migration of the fund to the UK. EAT now has a premium listing on the London Stock Exchange. This move to the UK was motivated by many considerations, including the fact that a large majority of the trust’s shareholders are UK residents and that it would also create the potential, recently realised, to reduce ongoing charges (see Fees and charges section on page 9).

Cosh and Morris seek high-quality companies, which they define as those with sound business models, high margins and returns and very strong balance sheets, with scope to deliver strong cash flows and superior returns over many years, even in difficult environments. An assessment of the strength of a company’s competitive advantages is also essential to their selection process, as the managers look to invest in ‘structural winners’, rather than cyclical growth or value.

The managers adopt a well-established, bottom-up, fundamental analysis approach and are supported by BMO Global Asset Management’s well-resourced small-cap and global equities teams. They produce detailed analysis of each potential investment, including valuation targets and sell triggers. Cosh and Morris’s approach is benchmark agnostic and they are happy to adopt a contrarian stance when a business satisfies their investment criteria.

Although the managers’ focus is on quality, they believe that valuation is an important driver of returns. They are disciplined about adopting or adding to positions only at the right price. They look for companies that trade at a substantial discount to their intrinsic value. Companies that meet EAT’s investment criteria but are not trading at acceptable valuations are placed on a ‘patient fisherman’ watchlist of stocks, awaiting a better price entry point. Although EAT purchased several names from its watchlist during 2020, the list continues to evolve with the addition of new companies.

EAT’s managers believe that solid environmental, social and governance (ESG) credentials are essential if a business is to succeed over the long term. Considerations regarding the sustainability of a company’s production process, its carbon footprint, and its treatment of its suppliers, employees and customers are thus integral to EAT’s investment process. The managers are supported in this regard by input from BMO Global Asset Management’s large and experienced Responsible Investment (RI) team. This team uses a scoring system which is developed using input from several external sources, such as MSCI and the Institutional Shareholder Services Group (ISS), but adapted by the RI team to take account of the most relevant factors. The trust’s holdings are not selected from a screened list, but the outcome of the scoring is accounted for both in the investment thesis for each company and in the managers’ conservative assessment of the intrinsic value of each company’s shares. Alongside this, during meetings, the managers engage with companies on ESG and sustainability matters and liaise with the RI team on further steps to be taken as a result of these engagements.

Cosh and Morris cite several portfolio holdings as examples of their focus on environmental issues, including Swiss food and beverage packaging company SIG Combibloc, which is Tetra Pak’s main competitor. SIG produces a range of environmentally friendly products, some of which allow food and drinks to be stored without refrigeration. The company also offers incentives for consumers to return packaging for recycling. Vidrala, another food packaging company and EAT’s top holding, uses recycled glass to replace plastic. While this is a more energy-intensive process, the company is investigating the use of electric furnaces to reduce energy use. Fluidra, a Spanish swimming pool parts and maintenance company, designs its products to minimise water use and wastage. EAT’s managers believe the efforts of these companies deserve greater recognition and they encourage them to be more vocal about their good environmental credentials, to inspire others to follow suit.

EAT has scope to borrow up to 20% of NAV, although historically, its use of gearing has been cautious. The managers began increasing gearing modestly in October 2020 to raise the portfolio’s exposure to the market’s recovery. Gearing peaked at 6% in November, although by end January 2021, net portfolio gearing had fallen to 4.8%. However, the managers have indicated that they may increase gearing in the future, depending on available opportunities and market conditions.

The trust has a €45m loan facility with the Royal Bank of Scotland International.

On 1 April 2020, the annual management fee received by BMO Global Asset Management was reduced to 0.75%, up to €400m of assets under management (AUM), and 0.60% on assets above this level. Previously, the manager received a fee equal to 0.80% of AUM, falling to 0.65% for funds in excess of €500m. Estimated ongoing charges for the year ending December 2020 are 0.95%.

Following the migration of EAT from the Netherlands to the UK in March 2019, the trust now has only one share class. As at 12 February 2021, there were 360.1m shares in issue. Historically, demand for EAT’s shares has been solid and the board has issued new shares to meet investor demand, although in the fiscal year ended December 2020, new share issuance amounted to only 0.2m, up only slightly from the previous year. No shares have been issued so far in FY21.

In March 2020, the board announced that with effect from the reporting period starting 1 January 2020, the reporting currency would change from euro to sterling and that all future financial statements would be presented in sterling. The board anticipates that this change will improve the clarity of the trust’s financial statements for its shareholders, the overwhelming majority of whom are located in the UK.

As part of the board’s plan to ensure an orderly succession as directors retire, in January 2021, the board announced that Pui Kei Yuen will be appointed to the board with effect from 26 February 2021. Ms Yuen has more than 20 years’ experience in asset management and investment banking. She will replace Laurence Jacquot, who will retire at the forthcoming AGM.