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Continental consistency

FUND FOCUS

While managers are talking up European equities – with stocks indiscriminately sold on concerns over peripheral countries – several sector stars have struggled over the past 12 months.

Morningstar data for the year to September 13, reveals the usual peer group leaders from Cazenove, Gartmore, Ignis Argonaut and Neptune languishing near the bottom of the sector – although all look more positive over longer timeframes.

Among the few funds consistent over all periods is Jupiter European run by Alex Darwall, which was in the top three performers for one, three and five years.

Darwall’s process is very much stock-specific, seeking out the continent’s world class businesses with a unique product or service driving global growth prospects.

As a result, Jupiter European’s ongoing outperformance is largely down to individual companies rather than broader themes, with the manager highlighting Novo Nordisk, Vopak, Novozymes and CGGVeritas as weathering the slowdown better than peers.

Darwall says: “Vopak, the Dutch-listed oil and chemical storage business, has continued to benefit from strong secular demand growth for storage while NovoNordisk, the world’s leading manufacturer of insulin drugs, recently enjoyed a significant new approval.”

The £1.26bn fund has also gained from avoiding utilities and commodities and an underweight position in financials, although DnB Nor in the latter sector has been one of Darwall’s best holdings.

The usual European ex UK stars are struggling, says James Smith, but fund managers that take a very stock-specific approach are putting in steady performance

He says: “Shares bounced back strongly after significant price weakness and DnB Nor’s profitability has been impressively robust, ducking most of the problems that beset European banks.”

Looking ahead, he notes a few themes underpinning his investment ideas, including the ongoing shift in economic power from East to West.

“We favour companies with strong balance sheets and productivity-enhancing and cost-saving products and services are attractive. Whatever the difficulties, some companies will prosper and as our holdings typically have a global spread of businesses, we are well placed to benefit from growth opportunities around the world.”

Elsewhere in the sector, BlackRock European dynamic is sixth over 12 months and first over three and five years.

Current manager Alister Hibbert has been at the helm since early 2008 and says he seeks companies that can significantly beat earnings’ expectations over the subsequent two or three years. He says these opportunities can come from either value or growth situations.

In his first year running the fund, Hibbert remained defensive, struggling to find stocks offering the required earnings’ upgrade cycle. This meant overweight positions in pharmaceuticals, food and beverages and a considerable underweight in financials.

By March the following year, however, he had already moved overweight financial stocks and benefited from their sharp bounceback throughout 2009.

Hibbert says: “We made this shift as it became clear the world situation was not as bad as had been widely thought, with banks in particular able to put out encouraging earnings reports in the first quarter of 2009, suggesting that areas such as non-performing loans had peaked.”

Other key overweight positions last year were various industrial recovery situations, as well as more classic cyclical opportunities such as German trucking company MAN.

By the end of 2009, Hibbert had already started selling financials down, concerned at the growing cost of funding, especially as sovereign debt problems in peripheral countries began to emerge.

He says: “We moved into more real economy cyclicals and have remained overweight there this year, focusing on areas such as luxury goods that benefit from high exposure to the growing Asian consumer.”

Hibbert is bullish on emerging market growth and this is a key theme across the European dynamic portfolio, with consumer discretionary stocks such as Nokian Tyres also a play on this. This is the world’s leading producer of winter tyres, which are vital in countries with heavy snowfall such as Russia and the CIS, as well as North America.”

Another rare consistent performer is Threadneedle European select, with manager Dave Dudding also passing his second anniversary in charge this year.

He has refocused the fund as a higher-conviction portfolio, cutting the number of stocks from about 70 to between 45 and 55 and generally taking bigger positions for the medium term.

Dudding says: “Threadneedle’s overall process focuses on pricing power, seeking out quality franchises that have a unique product or service in their part of the market.

“This leads us into areas of industry consolidation, where diminished competition means price rises are easier to get through and our holdings tend to have a quality growth bias on a three to five-year timeframe.”

European select is a best ideas fund but Dudding says the approach is low beta and the long-term growth bias means it outperforms in choppy or falling markets but can lag during major rebounds as seen last year.

His ongoing underweight position in financials has also been a major determinant of performance. This helped the fund in the first three months of 2009 and this year but was detrimental in the bank-led rally after March 2009.

He says: “Many banks are run too much for the short term, with bonuses based on annual performance, whereas at a company such as Nestlé, the management is incentivised to take a longer-term view.

“We are also relatively cautious on European economies and therefore skewed toward exporters, with banks largely a domestic play.”

Other themes running through the fund are Europe’s aging population, evident through an overweight healthcare position in stocks such as German dialysis company Fresenius.

Like many in the sector, Dudding is also positive on emerging market growth and holds companies such as Finland’s Kone, an escalator manufacturer, as a play on growing urbanisation.

He says: “As a group, we believe energy prices will remain high but feel the oil majors could struggle to grow and prefer to own stocks such as France’s Schneider, an energy management specialist.

“Consumer goods remain an important theme, with brands such as Nestlé boasting the brand, barriers to entry and emerging exposure we favour.”

Dudding’s country allocation has also been positive in the short term, helped by being overweight in Switzerland and light in Spain and Italy.

Among the less well known funds in the top 12-month performers, Invesco Perpetual’s European opportunities has already built a solid track record since launch in December 2007. This meant a tough debut year but manager Adrian Bignall moved early into financials in 2009, buying stocks such as Credit Suisse, Deutsche Bank and BNP Paribas and benefited as these rebounded.

He also added to cyclical stocks and sold-down smaller companies, running the group’s European smallcap funds alongside the opportunities mandate, before taking some risk off late last year.

Bignall says: “Sovereign debt problems have caused market weakness in peripheral eurozone economies, presenting many opportunities to buy stocks that are on already attractive valuations.

“Furthermore, the weakness in the euro is likely to benefit European corporate earnings later in the year.”

Overall, he remains focused on finding companies that can prosper in a low-growth environment as well as those where the team believe valuations fall short of true value.

He says: “The portfolio is well balanced, with a good mix of holdings across the market-cap spectrum. This includes healthy exposure to large-cap quality defensive holdings at one end, while also owning small and mid-caps we feel are well placed to benefit from any market recovery.”

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Tailwinds gather force

Jeff Taylor, head of European equities, Invesco Perpetual

We hear a lot about the headwinds but little about the tailwinds in European markets, probably because the headwinds make better headlines and, as such, European equities are probably loathed right now. But we think that is wrong – there is a strong case to be made for people taking Europe ex UK equities more seriously than they have in a long time.

A lot of survey indications coming out of the continent find outputs are still at very high levels and they do suggest we are a long way from an immediate double dip. There are also very low inventory levels held by European companies.

’We are searching for big-cap quality. The good guys who are good at market share and good at strong balance sheets. You can also get these at knocked-down prices right now, so you are essentially being paid to go up the quality scale’

During the crisis in 2008, European companies started with very high levels of inventory, which was a big problem but we are now at the opposite end of the spectrum and to me that is very important because it suggests an absence of this big negative.

We are searching for big-cap quality. The good guys who are good at market share and good at strong balance sheets. You can also get these at knocked-down prices right now, so you are essentially being paid to go up the quality scale, which is an unusual state of affairs.

There are also some good big-cap restructures going on in Europe, so you can buy yourself a safety net in the form of restructuring benefits to come.

Our portfolio is also looking at the dislocation caused by the sovereign debt crisis in the periphery and we are finding certain situations. This is because there has been a sentiment that Spain is in a very similar situation to Greece. We vehemently disagree with that, so we have added some Spanish blue chips.

There are always things to worry about but the sovereign problems are not news to the markets and it is already priced in. In Europe ex UK, you have access to a large number of extremely high quality companies that are often the best in the world at what they do and are often priced as if they were low quality rather than high quality. We think there is a decent chance that Europe ex UK will become a much more popular asset class than it is right now.

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Firms thriving amid diversity

Jaime Ramos Martin, European equity growth fund manager, Standard Life

Everyone looks at the bad side of what is happening in Europe but, for those who look at the good side, things have improved a lot. Germany, for example, is growing at its fastest pace since unification.

There are problems on the periphery and some of the countries there will have low growth for a long time to come but people who are picking stocks will have this in mind when looking at the companies in these countries. For example, in Ireland, you have Paddy Power, the bookmaker. These guys are now expanding across Europe and online, which offers them exponential growth. This is an example of a company thriving in a country facing terrible economic problems.

Spanish clothes retailer Inditex is another good example. It has seen nearly no market share increase in 18 months in the Spanish market but outside of Spain they are gaining a huge market share. To apply the same reasoning to these firms as to their countries is not right.

We are looking for stocks where things are going to improve and the market is also missing some of the growth opportunities.

Boskalis, a Dutch dredging company that also does a lot of port services, has a lot of opportunities.

We feel that the trade flows will be changing in the coming years. The flows were previously from emerging markets to developed markets but in the next five years we will see much more flows into emerging markets. That means if you are Boskalis and are looking at port development, there are a lot of ports to be built in Asia and Latin America.

The market gets too obsessed with the short term and it misses the picture and the opportunities for longer-term growth.

Through the crisis, a lot of companies have done a good job of cutting costs, releasing working capital and adapting to the environment and that has created huge cash piles. So now, for the first time since 2003, the free cashflow of the market is above the average deal of investment-grade corporate bonds. When that happens, it means companies have a lot of cash and this means there will be more buybacks or more mergers and acquisitions. That is all that is missing in the market right now but once that starts, it usually means good things for equities.

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Cash piles are building up

Olly Russ, European income fund manager, Ignis Argonaut

For corporates, things are a lot brighter than some of Europe’s governments. The peripheries are strapped for cash but a lot of governments in the Northern areas – namely, Germany, Switzerland and Scandinavia – are running balanced budgets, if not outright surpluses, so it has to be remembered that Europe is not all one piece.

Cyclical stocks are doing very well because many have overseas exposure and the emerging world seems to be growing fast. So there is money to be made with export firms but corporates in Europe generally are the complete opposite to their governments in the sense that they have too much money.

As a result, there is more M&A activity going on, with Telephonica and Portugal Telecom Vivo in Brazil and there is also BHP Biliton and Potash. A lot of European firms are using the cash they have to hand.

It is also worth remembering that the sovereign crisis does have an impact on government finances but because these countries are in the euro, they can access funds from the European Central Bank at basically 1 per cent. As a result, Greek mortgages are not based on Greek bonds, as they would have been in the old days. This means Greek mortgages are at around a 4 per cent spread against ECB, not 15 per cent Greek rates, so things are not quite as perilous as some might think.

The big story for next year will be capital return because there are all these piles of cash but there are limited investment opportunities, which means companies opt for acquisitions or they can return capital to shareholders and recognise they have got as big as they can and they need to focus on efficiency of use of capital.

Gradually, the cash will build and as things return to normal they will be more inclined to return money to shareholders.

Pick pricing power
Paras Anand, head of European equities, F&C

We accept that there remain material drags on headline economic growth, however, the current prices of bonds and cash reflect a negligible probability of any pick-up in inflation.

This is, we believe, a precarious position – while recent data on inflation has been dismissed on the basis that it has been driven by the impact of stimulus measures and the short-term impact of re-stocking, other pressures such as inflation in soft commodities and food prices and the impact of rising prices for goods imported from Asia appear more structural.

Additionally, one of the reasons that we have not seen more inflation is the failure of quantitative easing initiatives to get more money in the hands of those that really matter – the consumers. With banks a scale better off than their precarious position of a year ago, the inflationary impact of a second round of stimulus may be higher than currently expected. Finally, the majority of developed market governments desperately need some inflation in the system to help combat their current solvency positions. Overall, we find the current benign view of inflationary risks an uncomfortable one.

On this basis, we are focused on holding shares in good quality businesses and especially those with a proven record of pricing power, such as Credit Suisse, Akzo Nobel and Unilever. In this context, European equities – blue-chip stocks in particular – offer good value. The dividend yield on the DJ Euro Stoxx 50 index is currently 4 per cent, which compares with 3.3 per cent for the FTSE 100 index and 2.4 per cent for the MSCI World index. This yield is nearly twice that earned on German bunds.

We are different from other portfolios in two main areas – we are much more large-capfocused, as that is where we see not only the value but also the potential returns, and we are positive on financials where others are largely underweight in this sector. We believe there is clear value both in particular areas of the market and in Europe as a whole, particularly among large-cap companies. This is where we see the best investment opportunities on a long-term basis.

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