BlackRock Greater Europe Investment Trust — Exposure to niche, attractively valued companies

European equities have trailed the performance of the FTSE World index over the last five years (Exhibit 2, left-hand side), which has been led by the dominant US market. So far this year, global equities (including in Europe) have rallied sharply, recovering from the Q418 sell-off, due to increased confidence in a resolution to the US-China trade dispute, and a more dovish stance by the US Federal Reserve. As a result, average equity valuations are once again looking somewhat stretched. On a forward P/E multiple basis, both European and global equities are trading at a c 5% premium to their 10-year average (Exhibit 2, right-hand side). This valuation backdrop, coupled with slowing corporate earnings growth, suggests that investors considering European exposure may be rewarded by focusing on companies with sustainable growth potential and which are trading on reasonable valuations.

BRGE was launched in September 2004. The trust has two co-managers: Stefan Gries (since June 2017), who focuses on developed European markets, and Sam Vecht (since launch), who focuses on emerging markets. The managers aim to generate long-term capital growth from a relatively concentrated portfolio of 35–45 European equities. They employ a bottom-up stock selection approach and invest across the market cap spectrum (although the majority of holdings are above €10bn). BRGE is not benchmarked against a particular index, but the FTSE World Europe ex-UK index is used as a reference. Up to 25% of the portfolio risk allocation may be held in emerging European markets (currently three holdings making up less than 5% of the portfolio), and up to 5% may be held in unquoted securities (together, these two exposures may not exceed 25%). Investment in developing Europe may be direct or via funds (up to a maximum 15% of the portfolio), and direct exposure to Russia is limited to 10%. BRGE may invest in debt securities (none currently held), and derivatives are permitted for efficient portfolio management. Gearing of up to 15% of NAV at the time of drawdown is permitted; at end-April 2019, net gearing was 3.1%.

Gries comments that 2018 was an interesting year for investors; in Q118, there was optimism based on synchronised global economic growth – leading indicators were hitting new highs, including in Europe. The manager was not convinced by this rosy outlook and his view was borne out by the significant sell-off in world markets in Q418, when investors interpreted economic data as pointing to significant economic weakness. Gries stresses that he invests in companies on a stock-by-stock basis based on their earnings and cash flow potential, where these are not fully represented in a firm’s current share price. He does not look to change the shape of BRGE’s portfolio in order to anticipate stock market trends – for example, he did not buy in to the Q118 enthusiasm when financials were one of the outperforming sectors and he avoided the Q418 flight to safety, when there was wholesale buying of large-cap defensive companies such as Nestlé, Novartis and Roche.

The manager explains that the message he is receiving when meeting companies is that it is ‘business as usual’. In late November/early December 2018, freight forwarder DSV noted business was slowing, but not significantly, while speciality chemical distributor IMCD has reported that its business is on track. Gries believes that European economic growth will be lower this year than last, but he does not expect a recession. He says this view has been confirmed by recent economic data, which having weakened, are now starting to improve. There is evidence that Chinese stimulus is working and European chemical companies are reporting that Q219 volumes are picking up. The manager believes that a stabilisation in the macro environment would be good news for Europe, which has been meaningfully out of favour with investors. He notes that in 2018, Europe experienced significant outflows of capital, which have continued in 2019, so a change in investor sentiment would be very supportive for the European stock market.

Co-managers Gries and Vecht are able to draw on the broad resources of BlackRock’s European and emerging markets investment teams, aiming to generate long-term capital growth from a relatively concentrated portfolio of 35–45 European equities selected from an investible universe of c 2,000 companies. Valuation is considered on a stock-by-stock basis with a three- to five-year view. The managers consider the trajectory of a company’s earnings and cash flow, and look for situations where improving returns are not being reflected in the current stock price.

There are four primary investment criteria: a quality management team, with a record of value creation; a unique aspect such as a product, brand or contract structure; a high and predictable return on capital, with strong free cash flow conversion; and the ability to invest for future growth. Companies considered for investment undergo thorough fundamental analysis, which includes financial modelling and the compilation of a standard template. This provides a pipeline of potential investments. Meeting company management is a key element of the research process; the teams conduct c 1,000 meetings each year. Positions may be sold if the original buy thesis no longer holds true, if the investment case has played out (meaning a lack of further upside), or if a superior investment opportunity is identified.

Investment performance has improved since Gries became co-manager in June 2017. He has tightened up the investment process by strengthening the investment philosophy, moving to higher-conviction positions, delivering alpha (excess returns) more effectively, and opportunistic use of the investment trust toolkit, which includes the use of gearing.

As shown in Exhibit 1, the trust’s top 10 concentration has increased over the last 12 months from 35.7% at end-April 2018 to 46.9% at end- April 2019; four positions were common to both periods. Exhibit 3 shows BRGE’s breakdown by sector, compared with the FTSE World Europe ex-UK index. Its largest overweight is to industrials which includes the trust’s largest position, Safran, the market leader in narrow-body aircraft engines. The company has a very large installed base for its high-margin maintenance, repair and overhaul operations. Safran has provided earnings guidance as far out as 2025, which Gries believes is not being fully valued in the company’s current stock price. BRGE also has overweight exposure to the technology, healthcare (mainly medtech rather than pharma) and consumer services sectors. The trust has no exposure to the oil & gas and utility sectors, which together make up c 10% of the reference index. Over the last 12 months to end-April 2019, the largest changes in sector exposure are technology (+9.1pp), financials (-4.2pp) and industrials (-2.6pp).

The manager highlights one of BRGE’s relatively new positions. DiaSorin is one of the most profitable diagnostic/medtech companies in the world, producing and marketing in-vitro diagnostics (IVD) reagent kits used in immunodiagnostics and molecular diagnostics. The company operates in an oligopolistic market with a razor/razorblade model (selling modestly priced machinery and high-margin consumable products). Gries says that DiaSorin is rolling out a range of new IVD testing machines that have the potential to be game-changing, with smaller units allowing cheaper tests to be undertaken within a hospital rather than a laboratory environment. The company also has a joint venture with US-based QIAGEN, which the manager thinks has good growth potential. He is looking for a reacceleration in DiaSorin’s sales growth, which he believes can be sustained for at least the next three to five years. The manager says that the company ticks the four key boxes: a quality management team, operating in a growing market, generating a high return on capital and robust levels of free cash flow, allowing investment in future growth. Gries argues that DiaSorin is under-researched and is an example of how BlackRock’s well-resourced investment team can unearth undervalued stocks that have good investment potential.

Recent complete disposals include Eiffage, Inditex and Volvo. Gries holds a position in French construction firm Vinci, which is favoured over peer company Eiffage; the manager says that there is always competition for capital in the fund, and each holding must warrant its place. He explains that the research template is just the start of the investment process; Gries and his team ‘keep the plates spinning’ by continuing to add to their knowledge of investee companies.

While acknowledging that Inditex is the best operator in the fast fashion sector, Gries says the industry is changing and has become more competitive, with a lack of pricing power. The company’s like-for-like sales have been disappointing and the shift to online operations has brought into question the future of its bricks and mortar assets. Gries also notes that the global nature of Inditex’s operations leads to earnings and cash flow volatility due to currency moves, making it more problematic to forecast the company’s results.

Volvo was sold for cyclical reasons. While the manager thinks that the company’s management team has executed well, he says the truck industry, particularly in the key US market, has peaked.

BRGE has had a strong period of performance over the last 12 months. Its NAV and share price total returns of 9.3% and 11.0% respectively are well ahead of the FTSE Europe ex-UK’s index total return of 2.5%. Gries comments that the majority of this outperformance is due to stock selection rather than geographic and sector allocation. He is encouraged that a “diversified stream of alpha” has been generated across a range of countries and industries by following an investment process that focuses on companies that can over-deliver on earnings and cash flow, and where the business strength is not fully reflected in current consensus estimates.

Top contributors to performance over the past year include French aircraft engine manufacturer Safran, Swiss chemical and biotechnology firm Lonza, and Danish pharma company Novo Nordisk. Gries comments that BRGE underperformed in Q418 when there was a flight to safety; the trust has no holdings in some of the large defensive index names including Nestlé, Novartis and Roche. The manager believes that these companies have not over-delivered, but instead have become more expensive and therefore do not offer a compelling investment case. He comments that you “need to own businesses for the right reasons.” There were also a few positions that detracted from performance over the last year, such as Danish financial company Danske Bank, which was caught up in a money laundering case in Estonia and is facing a fine from US regulators. The manager and his team remain close to the situation and will continue to evaluate the potential for Danske Bank’s shares in light of new information.

Exhibit 6 shows BRGE’s relative returns. Its NAV and share price total returns are above those of the reference index over one, three, five and 10 years. The trust has also outperformed the FTSE All-Share index over these periods. BRGE has broadly kept pace with the performance of the FTSE World index over the last decade, although it has lagged in NAV and share price terms over one, three and five years, which have been characterised by the strong performance of the US stock market (the US makes up c 60% of the world index).

BRGE’s shares generally trade within a fairly narrow range relative to its NAV (Exhibit 7). Its current 4.4% share price discount to cum-income NAV compares with the 1.5% to 7.6% range of discounts over the last 12 months. It is broadly in line with the 4.3% to 4.8% range of average discounts over the last one, three, five and 10 years.

The board actively manages the discount via periodic repurchases and discretionary semi-annual tender offers for up to 20% of shares outstanding. So far in FY19, 1.4m shares (1.7% of the end-FY18 share base) have been repurchased at a cost of £4.9m. On 25 March 2019, the board announced its decision not to implement a semi-annual tender in May 2019.

Following the final conversion of subscription shares in FY16, BRGE is a conventional investment trust with one class of share – 85.0m ordinary shares in issue, with a further 25.4m held in treasury. The trust is permitted to gear up to 15% of NAV at the time of drawdown and has a £20m overdraft facility. Net gearing at end-April 2019 was 3.1% (broad range since inception of c 15% gearing to c 10% net cash). BlackRock is paid an annual management fee of 0.85% of NAV and no performance fee is payable. In FY18, ongoing charges were 1.09%, which was a modest 1bp lower compared to 1.10% in FY17.

BRGE has a progressive dividend policy, with annual distributions increasing every year since the trust was launched in 2004. Since 2014, dividends have been paid twice a year in May and December, rather than a single annual payment. The 5.75p (1.0x covered) FY18 total distribution was up 5.5% year-on-year, which is greater than the 5.0% compound annual growth rate over the last five years. At end-FY18, BRGE had distributable reserves of £10.9m, which is c 2.2x the last annual dividend. The trust currently offers a 1.6% dividend yield.

In Exhibit 8, we show the eight constituents of the AIC Europe sector. BRGE’s investment performance is above average over all periods shown, ranking third over one year (4.9pp higher than average), third over three years (+7.0pp), third over five years (+7.5pp) and second over 10 years (+9.6pp). The trust has the second-narrowest discount in the group, where none of the funds trade at a premium. BRGE has the highest ongoing charge in the sector, but in common with the majority of its peers does not charge a performance fee. Its level of gearing is broadly average, and befitting its focus on capital growth, BRGE has a below-average dividend yield.

BRGE has a relatively small board with four directors, all of whom are non-executive and independent of the manager. The chairman is Eric Sanderson, who joined the board in April 2013 and assumed his current role following the November 2016 AGM. The three other directors and their dates of appointment are: Davina Curling (December 2011), Peter Baxter (April 2015) and Paola Subacchi (July 2017).