TR European Growth Trust — Strong returns from European small-cap specialist

After the political drama of 2016, with the people of the UK voting to leave the European Union and the people of the US backing Donald Trump for president – in both cases contrary to expectations – potential upsets in 2017 as a result of European elections have so far been avoided. Both France and the Netherlands have elected stock market-friendly leaders, and European equity markets (as elsewhere) have continued to advance. While clouds remain on the horizon – such as for how long the European Central Bank can continue to provide liquidity to the markets through quantitative easing, and what will happen when it stops – with the normally quieter summer months approaching, it is possible the benign market trend could continue for some time.

As shown in Exhibit 2 (left-hand chart), having slightly underperformed for most of the past decade, European smaller companies have outperformed the broader European market over the last 12 months (total returns in sterling terms). This suggests investors are feeling more positive on the outlook for the European economy, as smaller companies tend to do better in periods of higher growth. This in turn may have led to higher forward P/E valuations (right-hand chart); however, while European small-caps currently look more expensive than the global large/mid-cap average, they offer more favourable forward P/Es and dividend yields than the global smaller company average. In an environment of higher average valuations, a strategy that focuses on identifying pockets of misvaluation could find favour with investors.

TR European Growth Trust (TRG), launched in 1990, has been managed by Henderson Global Investors since Henderson acquired the original management group, Touche Remnant, in 1992. Portfolio management is the responsibility of Ollie Beckett (since 2011), assisted by Rory Stokes since 2013.

The trust invests in a diversified portfolio of European (excluding UK) small and mid-cap companies, with the aim of achieving long-term capital appreciation. The managers prefer to seek undervalued opportunities in the less liquid, smaller end of the market, which leads to a longer stock list than peers in order to mitigate risk. Performance is measured against the Euromoney Smaller Europe ex-UK index. Portfolio construction is largely unconstrained, although there is a limit of 7% of total assets (at the time of investment) in any single holding. In practice, most positions are less than 2% of total assets. Although TRG has a growth remit, it also has a 12-year history of year-on-year ordinary dividend growth, and special dividends have been paid in 11 of the last 13 years.

Beckett points out that having moved sideways for a number of years, the European economy is now performing more in line with the global economy. In such a recovery phase, with the re-emergence of a degree of inflation, value/cyclical stocks and smaller companies tend to outperform (see Exhibit 2 for evidence of recent small-cap outperformance in Europe). However, Europe has been out of favour with overseas investors (including those in the UK), who have been more focused on political noise than company fundamentals.

Until the middle of 2016, European markets had seen a prolonged period where price momentum was the principal driver of returns – that is, stocks that had gone up continued to do so, with little regard for their underlying fundamentals. Beckett says public market investors had tended to ignore companies without share price momentum, even where they offered significant value. Private equity investors, with more of an emphasis on underlying value, took advantage of this, leading to the acquisition of listed companies such as Kuoni (bought out in early 2016 by EQT Partners at a c 30% premium). Beckett and Stokes, while not ‘value’ investors in the sense of concentrating only on stocks with the lowest P/E or price/book valuations (TRG’s average portfolio valuation metrics are close to those of the market), focus on finding stocks whose growth potential has been under-appreciated by the market. This led to an overweight position in banks during 2016, a strategy that paid off in performance terms as the sector rerated considerably towards the end of the year.

While European smaller companies are not cheap in a historical context, Beckett argues that their superior earnings growth potential means they should outperform large-caps. He points to the trend of large-cap fund managers moving into the mid-cap space to capture returns as evidence that this growth potential is becoming more widely appreciated. Beckett intends to maintain his focus on out-of-favour companies at the smaller end of the market, where he sees more significant upside.

Fund manager Ollie Beckett and assistant Rory Stokes seek to construct a diversified portfolio of European small and mid-cap stocks where market misperceptions have led to undervaluation. The investment universe is broad, and the first step in filtering the c 1,300 available companies is to use screening techniques employed by Henderson Global Investors’ quant team, as well as the Holt discounted cash flow analysis tool to generate ideas and as a valuation ‘sense check’. Understanding the business is a fundamental step before making an investment decision, and the managers meet or speak to more than 600 companies each year in order to gain insights into stocks that may not be well understood by other market participants. They also make use of research from Henderson’s well-resourced European equities team and (to a lesser extent) external sources.

Once promising stocks have been identified, the managers use a range of metrics such as P/E ratios, EV/EBITDA, free cash flow and dividend yield to build a simplified valuation model. These inputs aim to ensure the managers pay the right price for a stock in relation to its growth prospects. In-house research and company meetings help Beckett and Stokes to assess quality of management, durability of the business model, drivers of growth and potential catalysts for revaluation.

Individual positions are sized according to conviction, although given the focus on the smaller, less liquid end of the market, they seldom exceed 2% of the portfolio. Holding a large number of names (139 at 31 March 2017) helps reduce stock-specific risk. The managers also take account of macro factors such as the oil price and foreign exchange rates. Gearing is permitted in a normal working range of up to 15%. Stocks may be sold when they reach valuation targets, if better opportunities arise elsewhere, or if deteriorating fundamentals call the original investment thesis into question.

TRG’s 139 holdings at 31 March 2017 was well above the average for the AIC European Smaller Companies peer group and reflects the trust’s higher weighting to less liquid smaller companies, which may offer significant upside potential but also a higher risk of loss. Concentration in the top 10 holdings has reduced slightly over the past 12 months, from 16.0% to 14.9%.

The long-standing legacy holding in unlisted neurosurgery play Brainlab remains the largest position, but by much less of a margin after a period of exceptionally strong performance by some of TRG’s listed holdings. Beckett continues to be open to exiting the Brainlab position at the right price.

While country and sector weightings (Exhibits 3 and 4) are an output of stock selection, Beckett says the trust has a cyclical bias, based on favourable valuations in areas such as industrials and financials. In H117 Beckett added to holdings in Dutch financial services firm Van Lanschot and German property lender Aareal Bank, which performed strongly in late 2016, as well as specialist materials firm AMG, whose shares are up 67% in 2017 to date. Beckett also has a focus on technological innovation, and during H117 added new holdings in Ion Beam Applications (proton beam therapy for cancer sufferers), and high-tech insulated container specialist Va-Q-Tec. The latter was bought at IPO, as was Swedish plumbing and electrical equipment supplier Ahlsell.

Portfolio turnover has been higher than usual in recent months, partly as a result of M&A activity. While the failure of a bid for 3D printer specialist SLM Solutions caused the share price to fall back after spiking up more than 50% on news of General Electric’s approach, Beckett is sanguine as he sees “huge opportunities” for the company and had hoped to hold it for the long term; he sold around one-third of the holding after the bid approach, locking in the higher price.

TRG has performed extremely strongly over the past 12 months, with share price and NAV total returns of c 50% compared with 32.6% for the Euromoney Smaller Europe ex-UK index (Exhibit 5). Having suffered a performance setback in the aftermath of the UK’s Brexit vote, Beckett’s increased commitment to holdings with exposure to the UK, coupled with his decision to maintain a relatively high level of gearing, paid off as these stocks performed strongly. Since the immediate post-referendum lows, kitchen maker Nobia (owner of the UK’s Magnet brand) is up 34%, Scandinavian ferry firm DFDS is up 40.5%, Irish hotel operator Dalata is up 52%, Irish building materials stock Kingspan is up 78% and Dutch housebuilder BAM, which has c 20% of its operations in the UK, is up 81.5%. All these returns are in local currency terms at 10 May and have been boosted for investors in TRG by the weakness of sterling. M&A activity has also been mainly positive, although the breakdown of a bid for SLM Solutions caused the 3D printer specialist to be the largest negative contributor in H117. As shown in Exhibit 6, TRG has outperformed both the small and large-cap European indices, as well as the FTSE All-Share index, over the majority of periods.

At 16 May 2017, TRG’s shares traded at an 8.9% discount to cum-income NAV. This is close to the narrowest point in 12 months, and compares favourably with one-, three- and five-year averages of 14.2%, 12.3% and 13.8% respectively. Having widened to a three-year high of 19.3% on 1 July 2016 following the Brexit vote, the discount has gradually narrowed since late 2016, mirroring a period of strong NAV performance. As noted below, 262,500 shares were bought back between late September and the end of October 2016, the first repurchases for more than four years.

TRG is structured as a conventional investment trust, with one class of share. At 16 May 2017, there were 49.7m ordinary shares in issue. In the last 12 months, 262,500 shares have been bought back at a cost of £2.0m. Since the removal of a hard discount control mechanism (triggered at a 10% discount) in 2010, buybacks have been infrequent, and those between September and October 2016 were the first since 2012. The trust has a £50m multi-currency overdraft facility with HSBC, of which £46.5m was drawn in euros at the 31 December 2016 half-year end, up from £33.5m at 30 June. The board has set a working limit of 15% net gearing, and the figure at 31 March was 9.0%.

Henderson Investment Funds, the trust’s Alternative Investment Manager (AIFM) under the AIFM Directive, delegates investment management to Henderson Global Investors. Henderson is paid an annual management fee of 0.6% of net assets, charged 20% to revenue and 80% to capital. A performance fee of 15% of outperformance may be paid if TRG’s NAV total return outperforms the Euromoney Smaller Europe ex-UK index by more than 1% on a three-year basis. Total fees are capped at 2.0%. For FY16, ongoing charges were 0.79% and there was a performance fee of 0.4%.

While TRG invests primarily for capital growth, its board also aims to increase the dividend steadily each year. The requirement for investment trusts to retain no more than 15% of their income can sometimes mean the trust would have to increase its dividend by more than the incremental amount targeted by the board, and in such circumstances the balance is paid as a special dividend. Special dividends have been paid in 11 of the last 13 years. For FY16 an ordinary dividend of 9.0p was supplemented by a special dividend of 2.5p. Excluding special dividends, TRG’s ordinary dividend has grown at a compound annual rate of 20.1% over the five years to FY16 (22.0% including special dividends). Based on the 16 May 2017 share price of 1,011.0p, TRG yields 1.1% (0.9% excluding the special dividend).

There are four investment companies in the AIC’s European Smaller Companies sector, of which TRG is the second-largest. Very strong NAV returns over the past 12 months have propelled TRG into first place in the peer group over one, three and five years, well ahead of the weighted averages. This has been accompanied by a slight narrowing of the trust’s discount. TRG has the lowest ongoing charges in the group, but is the only trust to charge a performance fee. Its gearing is the highest in the sector, which has been a factor in its recent outperformance. TRG has the second-highest yield in the peer group (including special dividends, which have been paid in 11 of the last 13 years and can thus be seen as customary), although its yield is still well below the average, which is skewed by European Assets Trust’s 6% capital distribution.

TRG has five independent, non-executive directors. Audley Twiston-Davies has been a director since 2000 and chairman since 2002. Martin Smith joined the board in 2008. Christopher Casey (chairman of the audit committee) was appointed in 2010, followed by Alexander Mettenheimer in 2011 and Simona Heidempergher in 2014. The directors have backgrounds in banking, accountancy and investment management.