European Assets Trust — Long-term capital growth and high yield

Europe’s economy has slowed more than expected over the past year, largely led by Germany, which was its engine of recovery in 2017 and early 2018. Growth was mainly powered by German exporters during a period of synchronous global economic expansion, but this sector has since become a source of economic weakness. Expectations for global growth began to moderate in early 2018; however, the escalation of US tariffs against its major trading partners, including China and the EU, have taken a toll on trade as well as investor sentiment. Germany’s economy is also being affected by weakness in its autos industry, which accounts for over 16% of its exports. In 2018, the value of German car exports suffered its first decline since 2013, hit by new emissions standards and a significant slowdown in demand from many of its major markets, including the UK and US, but most notably China where German car exports declined by 37%.

Earnings expectations for European companies have fallen, which is reflected in relatively high P/E ratios (as shown in Exhibit 2, RHS). The European Commission forecasts euro area GDP growth in 2019 to moderate to 1.2% (2018: 1.9%) and accelerate modestly to 1.5% in 2020. These forecasts assume that trade and policy uncertainty recedes or at least does not escalate, highlighting the importance of geopolitical developments to the direction of European equities in the near term.

EAT aims to achieve capital growth through investing in small- and medium-sized companies listed in Europe (ex-UK). The manager, Sam Cosh, follows a bottom-up and disciplined approach to select c 40 high-conviction stocks that can be held for the long term. The board employs a high distribution policy (see page 8) and EAT’s dividend yield of 5.4% is significantly higher than its peers. The trust was launched as a Dutch company in 1972 and migrated its legal seat and structure to the UK on 16 March 2019, where it is listed on the London Stock Exchange and is a member of the FTSE SmallCap and FTSE All-Share indices. The reasons for the migration include:

Cosh observes that equity market movements in Europe (and globally) have been driven by an extended period of exceptionally low interest rates and abundant liquidity since the global financial crisis. He notes that investors are very sensitive to geopolitical news and to changes in expectations for the direction of interest rates. Markets were very weak in Q418 when the Federal Reserve was on course to rein in liquidity, and then moved sharply higher in Q119 when it signalled that interest rates are on hold for the time being. The manager believes that exceptionally low interest rates have fuelled growth in global debt levels, which he notes are now higher as a percentage of GDP than before the global financial crisis, and may be storing up problems for the future. However, Cosh is not distracted by macroeconomic or political predictions; he focuses on identifying quality companies with resilient businesses and strong balance sheets that can deliver good earnings growth through economic cycles. The manager notes that, although European growth overall is stalling, there are also areas of strength supported by improving employment levels and stimulative fiscal policies. He also observes that underlying economic performances within the region are not uniform, for example Germany is presenting a drag on Europe’s growth, but he thinks Spain has brighter prospects. Cosh believes that EAT’s fundamental and disciplined long-term investment approach, with a focus on capital preservation, is particularly relevant in the current uncertain environment.

The manager’s investment process is disciplined and bottom-up. Meeting companies is a key element, seeking well-managed, quality companies with sustainable competitive advantages. These may be derived from a company’s scale, brand recognition, intellectual property or know-how, or the strength of its business relationships. Valuation discipline is important and the manager looks for companies that trade at a substantial discount to their intrinsic value, which are capable of generating multi-year superior returns and strong cash flows. Cosh is supported by a well-resourced BMO European equities team, comprising 10 members. The team produce detailed, proprietary research for each candidate stock, which includes valuation targets and specific triggers for the sale of a stock. Companies that meet the manager’s investment criteria, but are not currently attractively valued, are added to his ‘patient fishermen’ list of stocks, awaiting a better price entry point.

The portfolio has four broad investment themes:

Exhibit 3 (LHS) shows EAT’s industry exposure and the change over the past year to end-May 2019. During this period, most of the portfolio activity took place in H118 when the manager turned more cautious on the outlook for European equities. At that time, Cosh thought that Europe’s economic recovery was maturing, and cyclically exposed companies were at risk of earnings disappointments and share price corrections. He reduced the portfolio’s exposure to what he viewed to be relatively expensive stocks with cyclical earnings, in favour of companies with secular growth prospects. This is reflected in the portfolio’s shift in sector weights over the past 12 months to end-May 2019, most notably an 8.8pp reduction in industrials, a 4.1pp increase in consumer services and a 3.9pp increase in healthcare. The main sales and purchases were discussed to our recent reports published in January 2019 and July 2018.

Over the past six months, portfolio activity has been light as the manager believes that the changes made to the portfolio last year continue to be valid, and that the fund should be relatively resilient in the current uncertain environment. As shown in Exhibit 3 (RHS), the EAT portfolio has significantly higher profitability (as measured by ROE) and lower levels of debt compared to the EMIX Smaller European Companies ex-UK index. However, the valuation of EAT companies is only marginally more expensive than the index in forward P/E multiple terms.

EAT has recently purchased a position in food processing company, Marel (Iceland). The company is one of the world’s largest manufacturers of food processing machinery with operations in over 30 countries. It has a leading position in the poultry business, which accounts for c 60% of profits, with a global market share of around 20%. The manager believes Marel can benefit from decent organic growth as the industry becomes increasingly automated, which helps raise manufacturers’ efficiency as well as reduce contamination risks and improves the traceability of meat through the production process. Cosh also thinks the company’s margins can expand over time as there is scope to improve the margins of its meat and fish businesses towards the level achieved by the poultry business. Furthermore, the company plans to be an industry consolidator, which may provide additional upside to growth estimates. The manager participated in Marel’s secondary listing on the Amsterdam Euronext exchange in June 2019 at a slight discount to its previous three-month average share price, which the manager believes was an attractive entry point.

In January 2019, EAT disposed of its long-held position in French automotive parts supplier Plastic Omnium. The company has been successful with its exterior body parts products, which are 30% lighter than metal and reduce carbon dioxide emissions. The development and growth of this business was a key part of the manager’s investment case in 2013. Looking forward, however, Cosh believes the company faces multiple headwinds, including trade uncertainties (it exports to c 25 countries) and regulatory risk, as governments seek to raise testing standards and reduce the sales of internal combustion engine vehicles.

Over the six months to end-May 2019, the manager has also added and trimmed positions as valuation opportunities presented themselves. Additions included glass bottle manufacturer Vidrala (Spain) and food services company Sligro (the Netherlands). Trims have mostly been to cyclical companies on strong share price performance, including construction and industrial elevator manufacturer Alimak (Sweden), and reverse vending machine manufacturer Tomra (Norway).

As shown in Exhibits 5 and 6, EAT has delivered strong long-term performance with an annualised 10-year NAV total return of 15.1%. Over five and 10 years, EAT’s NAV total return has outperformed the EMIX Smaller Europe ex-UK, FTSE AW Europe ex-UK and FTSE All-Share indices. The three-year numbers are relatively weak and reflect a pronounced underperformance following the result of the UK’s European referendum in 2016, for which EAT was poorly positioned. The trust held a number of Ireland-listed companies, which were heavily exposed to the UK domestic economy and sterling.

Cosh has a long-term investment horizon and focuses on company fundamentals, without significant regard for political developments. He noted that many of the firms that suffered sharp share price falls following the Brexit vote did recover and make subsequent positive performance contributions to the portfolio. EAT’s own attribution analysis shows that positive stock selection is the main contributor to its performance. For H119, the fund outperformed its benchmark by c 4%, which overwhelmingly attributed to stock selection.

EAT is currently trading on a 8.1% discount to cum-income NAV, which is significantly wider than its three-year average of 3.6%. The board actively monitors the trust’s share price volatility relative to its NAV and has the ability to manage the demand and supply balance for EAT’s shares through share issuance and repurchases. The board anticipates that, following the trust’s migration to the UK, demand for EAT’s shares may benefit from its premium listing on the LSE and its inclusion in the FTSE SmallCap and FTSE All-Share indices.

The migration of EAT NV from the Netherlands to the UK was completed on 16 March 2019 and shareholders of the Netherlands-registered company received one ordinary share of the UK-registered company (EAT). EAT has one class of share and, following a 10-for-one stock split in May 2018, there are 359.8m shares ordinary shares in issue and none held in treasury. Demand for the trust’s shares has historically been robust, and the board has issued new shares to meet demand. During FY18, EAT issued 12.1m new shares raising £15.4m (in FY17 the equivalent of 15.3m shares were issued, raising £19.8m).

EAT has a €45m loan facility with RBSI; as at end-May 2019 it was ungeared and had a net cash position of 0.2%.

The board has a distribution policy (barring unforeseen circumstances) to pay an annual dividend equivalent to 6% of the trust’s NAV as at the end of the preceding year. Dividends are funded from income and distributable reserves. The board has announced 2019 total dividends of €0.0684 per share (2018: €0.088), reflecting a 16.3% decline in the trust’s euro-denominated NAV total return (with dividends reinvested) for the year to end-December 2018. The 2019 distribution will be paid in four instalments in January, March, July and October. Following EAT’s migration to the UK, dividends paid in July and October 2019, and thereafter, will no longer be subject to Dutch withholding tax. Dividends for 2019 in sterling terms will be determined by the sterling-euro exchange rate prevailing on the dates and, at the current rate, suggest a prospective dividend yield of 5.4%.

Exhibit 9 shows the AIC European Smaller Companies sector, which consists of just four funds. EAT’s NAV total return ranks second over one and 10 years, third over three years, and fourth over five years. Its ongoing charge ranks second and there is no performance fee. The trust’s discount to its cum-fair NAV ranks third however, the current 8.1% discount to cum-fair NAV is wider than usual. Typically the trust has traded close to its NAV and the average discount over the past three years is 3.6%. It ranks first for dividend yield which, at 5.6%, is significantly higher than its peers.

Prior to the migration to the UK, in accordance with Dutch corporate governance requirements, EAT had a two-tiered board comprising a supervisory board and a management board. Following the migration, the management board is no longer required and the trust has a unitary board composed of all five members of the previous Dutch supervisory board. Chairman Jack Perry was appointed in 2014. Deputy chairman professor Robert van der Meer and senior independent director Julia Bond were appointed in 2007 and 2014 respectively. The other directors and the dates of appointment are Laurence Jacquot (2011) and Martin Breuer (2016).