Investors are likely to be missing out on attractively-valued opportunities in Europe because of short-term macroeconomic noise, according to Mark Nichols.
The manager, who runs the Threadneedle Pan European Equity Dividend fund, says that nerves surrounding political instability in the region combined with the recent Brexit vote have led many investors to avoid the market area from their portfolios altogether.
However, with a bottom-up stock selection process and a genuinely long term-time horizon, he says there are plenty of attractive opportunities in the region.
“It’s fairly topical because most of the questions we get at the moment, whether it’s from clients or whether it’s from colleagues or members of the press tend to be about what’s going on in the world and what my view is of Brexit, what will happen to the European Union, how is the euro doing,” he said.
“We tend to make a real virtue of the fact that we don’t pay an awful lot of attention to any of those issues. We’re very bottom-up, we’re very focused on how companies work and how they create value.”
While European markets suffered a small dip following the UK’s vote to part ways with the European Union, the MSCI Europe ex UK index has outperformed the FTSE 100 by 1.99 percentage points since the results were announced, returning 7.44 per cent.
Performance of indices since referendum result
Source: FE Analytics
This hasn’t put everybody’s mind at ease though, given that European banks are struggling and that there are a series of political headwinds on the horizon for the region including the constitutional referendum in Italy in October and the general elections for Germany, France and the Netherlands next year.
Jordan Hiscott, chief trader at ayondo markets, says that the most surprising impact of the referendum was how much it highlighted the “fiscal precariousness” or European banks.
“Deutsche Bank, arguably the premier bank of Europe, is currently down for the fifth session in a row and thanks to a series of non-performing loans, or NPLs, Italian banks are now looking for a bailout. This presents serious problems,” he warned.
“In 2014 an anti-bailout rule was adopted by all, meaning banks’ shareholders, bondholders and some of their depositors would have to contribute in such a scenario. So are Germany still willing to come to the rescue, even if it’s technically illegal under EU law?”
FE Alpha Manager David Coombs, who is head of multi-asset at Rathbones, has minimal exposure to the Eurozone across his portfolios at the moment and describes the market area as a “value trap”.
“I have very little exposure to the eurozone at all. People keep telling me that Europe is cheap but the contagion risk is quite high within the eurozone now following Brexit,” he said.
“I think there’s a lot of political instability coming up in Europe and Brexit has given the whole notion of leaving the EU credibility.”
“I reduced my exposure in the run-up to Brexit and when the Brexit looked more and more likely I reduced Europe more than I did my weighting to the UK. I’ve hedged the Euro since the Brexit as well.”
However, Nichols says that investors’ fears around buying into Europe have boosted the number of exciting opportunities in the market space, so long as investors do their research and truly look under the bonnet of the companies they’re investing in.
“However many managers you go round, generally they’ll tell you they have a 12-month window [to make investments]. We tend to say we have a three to five-year investment window. Someone is not telling the truth and I suggest it’s not us, but those holding periods are short and they’re getting shorter,” he explained.
“Part of that is because we have things like smart beta, high frequency trading, short-term trading, strategies in hedge funds and various other things.”
“What it does is create an inefficiency. If the market broadly agrees that mean reversion happens and that its holding period is relatively short, the way you start to differentiate yourself is to look further out.”
“We say three to five years and frankly all we’re saying is we want to look for a time period beyond the market’s typical investment horizon.”
In order to take advantage of market short-termism, the manager looks for businesses that have a genuine competitive advantage over their peers and can deliver real pricing power over time.
Nichols says that these firms are able to sustain their excess returns for longer so are therefore good stocks to buy into during times of uncertainty and to hold over the long term.
“Ultimately value is the ability to deliver returns that are in excess of the capital. The longer you can do that, the longer you can compound those returns and the more value you create over time,” he continued.
“We’re looking for high return businesses with high barriers to entry, which is exactly what Warren Buffet would call a ‘moat’ around a business – we want a moat around all of our businesses.”
Examples of companies that he particularly likes include drinks manufacturer Campari (which is held in the Threadnedle European Select fund) , wine and spirits wholesaler Pernot Ricard and building materials company Kingspan.
Not only does he believe that these firms will be able to sustain excess growth over the long term, he says that each is invested in by its owner which creates an alignment with shareholder interest.
“Campari is 51 per cent owned by family, Kinnsman’s chief executive is the son of the founder and his family own about 30 per cent of the company, they’ve done a pretty good job over the last 40 years and we think they’ll do a pretty good job over the next 40 as well,” Nichols said.
“We think it creates more of an entrepreneurial spirit. We think it makes them more aware of the risks inherent with losing money. They don’t take on too much risk but when they do take on risk they understand what they’re getting involved in, that’s the kind of relationship we really like.”
Another factor that is important to the manager’s stock selection process is that the firms are global-facing in order to minimise any region-specific risks. He says that Europe is a particularly good hunting ground for stocks with international exposure given the vast selection of export-orientated firms in the market area.
“When you see the split of how our portfolio looks versus the benchmark [geographically], it doesn’t mean I’m taking on a macro risk with those countries,” he explained.
“If the Irish economy is broken, Kingspan is probably going to be alright. In fact, if the Italian market is broken, Campari will probably even do better.”
“In many ways I would say that when you buy a European equity fund, a majority of our companies are export-orientated. You’re not buying European economies, you’re buying European companies and we’re therefore trying to find the best European companies we can.”
Since Nichols took to the helm of the Threadneedle Pan European Equity Dividend, it has returned 14.5 per cent compared to its sector average’s return of 10.14 per cent and its benchmark’s return of 13.63 per cent.
Performance of fund vs sector and benchmark under Nichols
Source: FE Analytics
Over the same time frame, the fund is in the top quartile for its annualised volatility, Sharpe ratio (which measures risk-adjusted returns) and maximum drawdown (which measures the most potential money lost if bought and sold at the worst times).
Threadneedle Pan European Equity Dividend has a clean ongoing charges figure of 1.11 per cent and yields 3.6 per cent.
