European Opportunities Trust — Tough times expected to reaffirm a tested strategy

EOT was launched by Jupiter Asset Management in November 2000 and is now managed by Devon Equity Management (see our initiation note for details). Alexander Darwall, Devon’s chief investment officer, has managed the fund since its inception, first at Jupiter and subsequently at Devon, under the same investment strategy adopted at the trust’s launch. EOT changed its ticker to EOT from JEO in November 2021.

EOT’s objective is to invest in securities of European, including UK, companies and in sectors or geographical areas that are considered by the manager to offer good prospects for capital growth, taking into account long-term economic trends and business development. EOT’s benchmark is the MSCI Europe TR GBP Index, although the manager is not tied to investing in the benchmark’s constituent companies.

EOT invests primarily in equity and equity-related securities of issuers that have their registered office in Europe or conduct the predominant part of their economic activities in Europe (including the UK). Darwall employs an active, bottom-up approach to selecting investments. The portfolio is relatively concentrated, consisting of around 30–40 high-conviction investments. Its top 10 holdings usually represent around 70% of assets under management. The company is a member of the AIC Europe sector. It uses gearing tactically and has access to an unsecured committed £125m multi-currency revolving credit facility with Scotiabank, at 65bp above Libor.

Darwall is a high-conviction manager, with firm views on the factors that drive successful long-term investing and threaten sustainable corporate growth. At present he is particularly concerned about mounting inflation pressures and their potentially adverse impact on companies’ cost structures and earnings. He does not share the views of central banks that recent rises in inflation will be transitory. Rather, he expects inflation to be ‘persistent and damaging’, underpinned in part by the transition to renewable energy sources and the pursuit of ‘net zero’ carbon emissions objectives. Darwall believes that green energy will remain much more expensive than conventional energy sources, adding significantly to costs for producers and consumers.

The manager seeks out companies capable of generating profitable growth regardless of the economic environment. So companies’ pricing power has always been a key consideration, and he also favours businesses with low debt levels, which ensure protection from rising interest rates as central banks seek to dampen inflation pressures. These corporate attributes have become even more important to Darwall in light of the inflation risks he sees ahead.

Several additional investment criteria guide the manager’s efforts to build an ‘all-weather’ portfolio. He prefers high-value-added, globally focused businesses that benefit from unique technologies, favourable industry structures and high barriers to entry. The companies that appeal most to him are those that possess multiple growth channels, underpinned by structural, rather than cyclical, demand.

Darwall cites the Danish pharmaceutical company Novo Nordisk, EOT’s largest holding, as an example of the kind of innovative, strong and resilient stocks he favours. The trust has held this stock since inception. It is one of only two companies, along with Eli Lily, that supply most of the world’s diabetes care medicine, which gives it significant pricing power. In addition, Novo Nordisk is a world leader in the development of treatments for obesity. The company has seen very strong demand for its obesity drug since its approval for use in the United States last year. Diabetes and obesity are two of the western world’s major and growing healthcare challenges, so demand for Novo Nordisk’s products is likely to continue rising in the foreseeable future. The resultant cash flow will be partly reinvested into expanding production facilities and developing new products, such as even more effective obesity treatments, while some will be returned to shareholders through buybacks and dividends.

In fact, healthcare is one of the major themes underpinning Darwall’s investment decisions. In addition to EOT’s overweight position in Novo Nordisk, EOT has significant exposure to several other innovative pharmaceutical and life science stocks (Exhibit 1), and together these comprise the portfolio’s largest sectoral overweight (Exhibit 2). Holdings include bioMérieux, a French diagnostic testing company, and Grifols, a Spanish company specialising in blood plasma products – both top 10 holdings. The manager has also recently acquired exposure to Merck KGaA, a German life sciences, healthcare and electronics conglomerate. This company meets Darwall’s requirement for multiple growth drivers. For example, it produces specialty chemical inputs for semiconductor production, a clear growth area, as well as lipids, which are a key component of mRNA-based vaccines and therapies, including COVID-19 vaccines. Merck is also a leader in the field of biologics manufacturing and, according to Darwall, is ‘exceptionally well-placed to capitalise on continued growth in biologics and the imminent commercialisation of mRNA and gene therapies across a broad array of applications’.

Another key investment theme is digital technology. IT stocks are EOT’s second largest sectoral overweight. The trust owns German semiconductor producer Infineon (a top 10 holding). It also holds Soitec, a French producer of energy efficient silicon wafers that increase the battery life of mobile phones and wearable tech. This company’s unique technology means that is it well-placed to benefit from the 5G rollout and growth in the internet of things (ie equipment and devices run via the internet). Experian (EOT’s second largest position) is the world’s largest provider of credit data. It has a policy of ‘financial inclusion’, which Darwall believes will allow its business to continue growing as credit becomes more accessible to consumers of all socio-economic groups. The manager expects this trend to be encouraged by the arrival of new fintech companies, which will require credit data to manage their customer base. A position in cybersecurity company Darktrace adds further diversity to EOT’s IT exposure. This UK-listed company has a unique process that uses unsupervised machine learning to protect companies’ systems from cyber threats.

Darwall also sees several investment opportunities under the theme of ‘alternative finance’ (although the trust is slightly underweight financials relative to the benchmark). International Capital Group (ICG), an investment company focused on private equity, is one of EOT’s top 10 holdings and other financial names include Deutsche Boerse, the German stock exchange operator, another top 10 holding, Grenke, a German financial and leasing firm servicing smaller companies, and Worldline, a French digital payments company. Darwall has recently re-opened a position in this name based on its ‘respectable growth prospects’. He expects its leading position in the European market will ensure that it benefits from ongoing growth in this sector.

Despite his concerns about the cost implications of the transition to net zero emissions, Darwall believes that the green transition also provides opportunities for some companies. For example, he recently opened a new position in Neste, a Finnish company that is the world’s largest producer of high-quality renewable diesel and sustainable aviation fuels. Neste is also developing other renewable alternatives for the chemical industry. In the manager’s view, airlines will be able to switch to Neste’s aviation fuel without incurring major expenses, and he thinks the company enjoys ‘sustainable competitive advantages and strong growth prospects’.

Looking ahead, Darwall expects the investment environment to remain challenging. In addition to inflation risks, growth in Europe will lag the global recovery. The war in Ukraine is likely to hurt Europe more than other countries, due to the region’s reliance on Russian oil and gas. However, the manager remains ‘very confident’ that EOT’s strategy of identifying a spread of globally focused structural winners, that can flourish regardless of the prevailing economic climate, will help mitigate the risk of weaker European growth and continue to deliver capital growth for shareholders over the long term.

EOT’s portfolio turnover is usually relatively low. Several stocks – in addition to Novo Nordisk, mentioned above, Dassault Systèmes, a French software company, and RELX, a UK business information and analytics company – have been held since inception and EOT has owned over half its holdings for more than six years. During the 12 months to end November 2021, turnover was 19%, which is lower than in recent performance periods.

The most significant sale during the trust’s financial half year to end November 2021 (H1 FY22) was the disposal of half the portfolio’s holding in private equity investor ICG. This provided funds for more attractive opportunities and was also motivated by Darwall’s concerns about the high levels of debt used by private equity firms. However, ICG remained among EOT’s top 10 holdings in February 2022. The manager also trimmed exposure to Novo Nordisk for risk management purposes when its portfolio weighting increased to 11.3%, although it remains the trust’s largest position. A position in Arrow Global, a UK asset manager, was closed at a profit following a successful takeover bid. Other disposals during H1 FY22 were relatively small. In the three months since then, the manager has reduced exposure to ASML on valuation grounds and closed a position in Ubisoft Entertainment, a French gaming and multimedia company (see discussion below).

In terms of purchases during H1 FY22, in addition to the new positions in Neste, Merck and Worldline, discussed above, Darwall has been building EOT’s out-of-index position in cybersecurity company Darktrace. Recent share price declines have made the stock more attractive and the manager’s confidence in the business’s prospects was boosted further by a recent company visit. He expects a new product launch later this year to add further momentum to the company’s already strong growth outlook. The proceeds of sales made since the end of H1 FY22 have been used mainly to add to existing holdings in Soitec, Mowi, which is a Norwegian company and the world’s largest producer of farmed salmon, and Bayer, a German pharmaceutical and crop science company.

The manager’s high conviction approach results in a very concentrated portfolio that held only 28 stocks at end February 2022, compared to 31 at the time of our initiation note published in September 2021. As suggested by Exhibit 1, positions tend to be large relative to the benchmark. EOT’s top 10 holdings comprise almost 70% of the portfolio, and over 50% of the portfolio is held in the healthcare and tech sectors (Exhibit 2). The trust’s most notable underweights are in consumer sectors, materials and utilities. It does not hold any stocks listed in Russia or Ukraine, and none of its portfolio holdings have significant exposure to either of these countries.

The manager adopts a tactical approach to gearing. He tends to increase it during periods in which he believes valuations are excessively low and reduce it as markets recover. This approach has added sustained value over the course of the trust’s life and the board continues to encourage the manager to use gearing to enhance returns. At end-February 2022, gearing stood at 8.2%, compared to 6.8% at 30 November 2021 and 3.7% at end August 2021.

EOT’s long-term performance has been strong, but recent returns have been more volatile. In the 10 years to end February 2022, the trust’s annualised total return has been 11.4% in net asset value (NAV) terms and 10.9% on a share price basis, compared to an annualised return of 8.7% on the trust’s benchmark, the MSCI Europe Index (Exhibit 4, right-hand side). EOT’s NAV performance has also slightly outpaced its benchmark over five years. However, in the last financial year ended May 2021, the trust experienced a rare year of underperformance, for two main reasons. Returns were adversely affected by the trust’s exposure to the Wirecard fraud. EOT’s bias towards high-quality companies also weighed on returns during this period, as these stocks lagged more economically sensitive names in late 2020 and early 2021, during the ‘recovery rotation’, when the economic outlook was transformed by the arrival of COVID-19 vaccines (see our initiation note for details). EOT’s performance improved during its most recent reporting period. It returned 12.8% on an NAV basis and 9.9% in share price terms over the six-month period to end November 2021 (H1 FY22), compared to a benchmark return of 3.8%.

Performance during H1 FY22 was supported by the strong performance of several of EOT’s largest positions, all of which have portfolio weights significantly above the benchmark (see Exhibit 1). The biggest contributor to the performance was top holding Novo Nordisk, whose share price was supported by extremely strong demand for its obesity drug, following its launch in 2021. Experian, EOT’s second largest holding, also added to returns, as did RELX, the trust’s third biggest position. Strong growth in RELX’s fast-growing risk business supported the share price. Another key contributor to H1 FY22 performance was Dassault Systèmes, EOT’s fourth largest position. The company provides 3D design, printing and related products and services to many sectors in the global marketplace. Recent performance has been boosted by pandemic-related business. Demand for COVID-19 tests ensured bioMérieux also did well. The manager expects bioMérieux’s broader product range to continue to experience strong growth thanks to a structural increase in demand for diagnostic services, for viruses and other ailments. Darwall recently added to this position. EOT’s semiconductor related stocks, including Infineon Technologies and Soitec, performed well thanks to current strong demand in this sector, which is underpinned by the expanding market for electric vehicles and the internet of things. The manager expects these companies’ leading positions in their respective market niches to allow them to maintain their good performances.

Detractors from H1 FY22 performance included drugs manufacturer Grifols, but the manager has maintained an overweight position in this ‘chronic’ underperformer, as he expects COVID-19 related plasma collection problems to dissipate with time. He also views new therapies (such as neonatal fragment crystallisable receptor inhibitors) as complementary, rather than competitive, as some investors fear. Darwall also likes the industry structure and its prospects for robust demand growth.

At the sector level, the portfolio’s overweights to healthcare, IT and industrials, combined with it’s underweights to financials and materials, contributed most to returns during H1 FY22, while its minor underweights to communications services, energy and consumer discretionary names detracted modestly.

EOT’s performance has lagged in the most recent three-month period to end February 2022. The market correction seen since end H1 FY22 has had a disproportionally negative effect on the high-value healthcare and tech names favoured by Darwall. These stocks were hit particularly hard by fears of inflation and higher interest rates, and the portfolio’s substantial overweights to these sectors meant that EOT declined by 11.5% on an NAV basis and by 11.6% in share price terms in the three months to end February 2022, compared to a benchmark decline of 2.8%. At the same time, expectations of higher interest rates boosted financials, where EOT is underweight.

This recent underperformance is clearly disappointing and the trust’s share price has declined further this month, as has been the case with many investment trusts since the outbreak of war in Ukraine. However, Darwall believes this weakness is unjustified and should prove short-lived. He is keen to stress that almost all the news on EOT’s portfolio holdings has been good, in some cases better than previously expected, and certainly much better than suggested by their weak share prices. Significant detractors from performance in the past three months include Novo Nordisk, Experian, Dassault Systems and Soitec, yet their operational performance and prospects are, according to Darwall, ‘hugely encouraging’. While it is true that a supply chain issue has weakened Novo Nordisk’s share price, the manager expects this setback will prove to be a short-term ‘minor inconvenience’, which he is prepared to look through. Similarly, Soitec’s share price has declined on news of internal conflict around the succession of the CEO. However, Darwall expects this issue to be resolved in due course. In the meantime, the company’s latest results were ‘excellent’ says Darwall, and its growth prospects are good. He has taken the opportunity created by this short-term share price weakness to add to EOT’s position.

The adverse impact of these factors on recent performance was partially countered by the favourable influence of several other positions, including improvements in the performance of a couple of stocks that detracted in H1 FY22. Ubisoft Entertainment hurt returns during H1 FY22 as the company faced product launch delays and difficulties retaining staff. In addition, the Chinese government’s mid-2021 crackdown on online gaming dented demand in one of the company’s most significant markets. However, in January 2022 the share price rallied on news of Microsoft’s bid for Ubisoft’s competitor Activision Blizzard. Darwall took the opportunity to close the position in early February.

Bayer was hurt during H1 FY22 by persistent legal issues, which Darwall believes have distracted market attention from the fundamental merits of this company’s businesses, including in its Crop Sciences division, which, in his view, possesses some ‘world leading technologies’. The stock has since rebounded and Darwall believes it ‘still has a long way to go’. He has recently added to the position. Mowi has also performed well, and the manager has recently increased exposure on the view that cost pressures in the fisheries sector are likely to be less severe than in the meat and dairy industries, which are more subject to rising costs for energy, fertilisers and other inputs.

EOT’s shares have traded at a modest discount to its cum-income NAV over the long term, with the discount averaging 5.1% over five years and 3.0% over 10 years. The onset of the pandemic in 2020 saw the discount of many investment trusts, including EOT, widen sharply for a brief period. Between March 2020 and the Russian invasion of Ukraine in February 2022, EOT’s discount established a new trading range around 10%. Consistent with the experience of many investment trusts, the outbreak of war in Ukraine triggered a further widening in EOT’s discount and it is currently trading at 12.9% (Exhibit 6).

EOT’s board actively manages the trust’s discount and is committed to maintaining it in single figures in normal market conditions. During the half year to end November 2021, the trust repurchased a total of 2.2m shares to support the share price. Since then, it has repurchased a further 1.3m shares.

The board’s consistent efforts to support the share price may narrow the discount over time, especially if performance returns to trend and/or as investors come to appreciate the relative value EOT’s shares offer at their current, historically wide discount.

EOT is one of seven members of the AIC Europe sector (Exhibit 7). More than half of these trusts share EOT’s focus on growth rather than income, but EOT is unique in several ways. As discussed above, portfolio concentration is relatively high due to the manager’s high-conviction approach. The trust usually only holds 30–40 stocks and its top 10 holdings normally comprise around 70% of portfolio value, compared to around 40% among EOT’s peers. Unlike most of its peers, EOT also has a sizable exposure to UK-listed companies, as Darwall prefers to hold the best stock in its sector, even if it happens to be UK-listed. These distinguishing features mean that EOT’s portfolio is markedly different to those of its peers, with few, if any, stocks in common.

This means that comparing EOT with its so-called peers provides limited insight into its performance. However, for the sake of completeness, EOT is the second largest fund in its sector. Its NAV total return has exceeded the sector average over one year, but lagged over all other periods shown, although its performance over 10 years is close to the sector average. The trust has the widest discount, while its ongoing charge is slightly higher than average. Like its peers, it does not charge a performance fee. EOT’s use of gearing is close to the sector average.

EOT’s objective is to achieve capital growth, rather than income. And the trust invests in companies focused on structural growth. These investee companies tend to reinvest their earnings in further growth, rather than pay dividends to their shareholders, so the dividends EOT receives from its investments tend to be low. EOT’s policy is to pay out income equal to 85% of this investment income, the minimum required by legislation to maintain its investment trust status. This means that the trust’s dividend is quite low in absolute terms, and relative to its peers, and does not usually make a significant contribution to total returns. As can be seen from Exhibit 8, the dividend may fluctuate in line with its investment income.

In the financial year to end May 2021, the company paid a final dividend of 2.0p per share, down from 3.5p per share in the previous financial year. The dividend for the year to end May 2021 represents a yield of 0.3%, based on the current share price.

EOT makes one final dividend payment per year. It is expected to announce its final dividend for the current financial year ended May 2022 at the time of publication of its annual results, in September 2022. Subject to the agreement of shareholders at the annual general meeting, the dividend will be paid in November 2022.