Exposure to Italian financials and stocks “hated” by markets will be key to long-term outperformance in European portfolios, according to Mike Clements (pictured). 
The FE Alpha Manager, who runs a number of portfolios including the Oyster Continental European Selection fund, has achieved top-quartile annualised returns in 2015 and year-to-date as well as over his two-year tenure, despite his contrarian stock selection process.
While the MSCI Europe ex UK index has achieved a higher return so far this year than it did in 2015 and 2014, it is arguably the underdog area of the market having been outperformed by most other regions over this time frame.
Performance of indices in 2016
Source: FE Analytics
That said, the market has still rallied 12.58 per cent year-to-date. Not only this, there are a series of potential headwinds on the horizon for the region such as the continuation of ultra-loose monetary policy, post-Brexit repercussions and the demise of Italian banks as a result of non-performing loans.
Rather than hold high levels of cash and wait for valuations to improve and headwinds to subside, Clements is arguably placing his portfolio in the eye of the storm over the short term to lock in long-term gains for the patient investor.
For instance, his favourite stock within his Oyster Continental European Selection fund at the moment is Eurocastle, which resides in the unloved Italian financials sector and is the leading loan servicing company on non-performing loans in the region.
“Italian financials are a mess because of the bad loans it has on its balance sheet – there are €200bn of them. Everyone at the moment is trying to guess how to play the Italian financials – they’re cheap as chips, so long as they survive,” he explained.
“There are two ways of making money out of Italian financials right now – you either buy those bad loans at a very, very cheap price which is what the hedge funds are doing.”
“But also you need companies to go and physically collect the money and that’s what this company does. Out of the €200bn of non-performing loans in the Italian financial system, they collect about €40bn of them.”
“They don’t own the loans and they’re not exposed to them, apart from the fact that every time you collect €100 from someone who hasn’t paid, they take a cut of it. This is the best way, in my opinion, to play the Italian financials, and it’s very cheap because nobody looks at it because it’s a hidden part of the market that is too much work – there’s no information on it.”
Clements says that one of the advantages he has as a manager is the amount of research him and his team are able to do, given that they hold a concentrated portfolio of 30 stocks.
He disagrees with diversifying away risk because it detracts alpha and instead believes it is more important to conduct thorough research into each holding within a portfolio.
Compared to its peers, Oyster Continental European Selection has a top-decile alpha generation relative to the index and is completely benchmark-agnostic.
Another reason Clements says he is different from his peers is that he has a greater focus on absolute valuation rather than on a relative basis and is therefore strict about buying into attractive stocks that are trading on even remotely high valuations.
“Everyone loves the likes of Loreal, for instance. It has great brands, good management team, good growth prospects and I love it. The problem is everyone else loves it as well and that’s logical – if there are two companies in the same field you pay up for the good one,” he explained.
“My problem with that way of thinking is that the only time you can buy good quality companies cheap is when something bad is happening. I need fear, panic and distress in the market, I need to buy my equities from the guy that can’t be in oil stocks because the oil price is collapsing or can’t be in a Russian stock because Russia has just invaded Ukraine or couldn’t be in a company based in Spain because Spain is going bankrupt during the financial crisis.”
“I need to buy companies where people are focused on something other than fundamentals of the business, they need to be scared about a sector or a country, which drives share prices down in those areas to very low levels.”
Clements says that he and his team purposefully seek out the areas of the market or stocks that investors don’t like.
Another example of this is Swiss luxury watch manufacturer Swatch, which owns 20 brands and is 39 per cent owned by the Hayek family who founded the firm.
Clements particularly likes family-owned businesses as he says it aligns the management team’s interests with investors. He also points out that Swatch boasts cash on the balance sheets as well as a wide range of strong brands.
However, the stock has fallen by more than 25 per cent over the past year and is unpopular among many European investors.
“If you follow the luxury market at the moment it’s under a lot of pressure but the reason we like Swatch is because it has this attractive balance sheet. The family owns a big chunk of it. This is good and bad. Hayek is quite unusual in that he hates the stock markets,” the manager explained.
“The trade-off is that he’s not very good at talking to financial markets but the good thing is he runs his business in the interest of long-term wealth creation.”
“Hayek doesn’t care at all what the market thinks in the short term. He’ll take whatever he thinks is the right decision for the company based on a five or 10-year view which works well for us.”
Clements says that the firm’s margins are currently under pressure as its sales are being hit by macroeconomic headwinds. However, he says that this shouldn’t be a cause for concern for investors and that its lower share price has meant it is now an even more attractive investment.
“They have a very large marketing budget – they spend about 13 per cent of their sales on marketing. If they wanted to they could easily boost that margin just by slashing their marketing spend and that will keep the stock market happy in the short term, but that’s maybe not the right thing to do,” he continued.
“What he feels is the right thing to do is to keep advertising and promoting products so, when you come out of a recession in three or four years’ time, whenever it is, his position in the market is much stronger because he’s keeping his marketing presence up and he believes that is more valuable in the long term.”
“The market hate it – it’s one of the most shorted stocks in the market – but it’s a good example of a family ownership taking what I think are very long-term decisions, which is what we like.”
Over Clement’s tenure, Oyster Continental European Selection has returned 32.79 per cent, outperforming its sector average and benchmark by 15.87 and 19.53 percentage points respectively.
Performance of fund vs sector and benchmark under Clements
Source: FE Analytics
The £33m fund has an ongoing charges figure of 1.3 per cent.