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Sector Focus: European equities have gained from QE tapering

Europe still has problems to overcome but selecting market leading companies with a global reach has paid dividends for the best managers says James Smith

Europe ex-UK is perhaps the most consistent fund sector, with many of the same names leading the way year after year.

As he has for much of the time since taking on Threadneedle European Select in 2008, David Dudding heads the peer group over three years to end September, stressing the continent’s world-class businesses despite the difficult macro backdrop.

Threadneedle’s investment philosophy has three pillars, an active approach to take advantage of market inefficiencies, appropriate allocation of risk and combining macro and micro to produce what the group calls its perspective advantage.
 This latter element is key in Europe, where – although there are signs of recovery – Dudding says it is hard to be positive on growth for the next five to ten years.

“Europe has its macro and demographic challenges but for us, the continent is full of world-leading companies
. A further key factor is the global reach of many businesses, with companies often forced to grow outside their borders. With just 18 million people in Holland for example, Dutch businesses have an incentive to seek customers in growth areas of the world and this model means many European corporates are not purely dependent on their home economy,” says Dudding.

Pricing power is integral to Dudding’s stockpicking, with the ability to set prices in an industry a key attribute for his holdings and a major driver of overall returns.
Looking around Europe, Dudding notes a telecom versus cable stock story in several countries as the best example of pricing power at work.

He says: “In Germany for example, Kabel Deutschland has strongly outperformed Deutsche Telekon in recent years and the same goes for Iliad versus France Telecom and KPN versus Ziggo in the Netherlands.
 Key to this cable over telco call is pricing power, with the former benefiting from lower costs, superior technology among the small, newer players and lack of legacy infrastructure. Mobile is also a highly competitive market while fixed line is far more concentrated.

“We are getting to a point where few people care about their phone tariff, forcing companies to keep on slashing price. Competing on price like this is a red flag for us and we have therefore been zero weighted in telco names and held all the cable companies outlined plus further Belgian and Portuguese businesses. This highlights the value of strong analysts and the benefits of a focused approach, with the telco sector still among the biggest in the European index.”

With the pricing power theme leading to a consumer goods bias in the portfolio, Dudding argues against claims this sector is fundamentally overpriced and urges investors to look beyond surface price/earnings ratios.
Elsewhere, he notes companies meeting his criteria across a range of sectors from chemical distribution, to radiation therapy providers to non-life insurers.

Materials is another overweight and financials remains a long-term underweight, although the position has been growing in recent years.

Elsewhere, Jupiter’s Alexander Darwall is another ever present in the sector’s top performers, also focusing on Europe’s world-class companies.
 With that in mind, he said the continent’s lacklustre economic backdrop is largely irrelevant to both his investment process as well as general investment prospects.

Darwall says: 
“Instead, we believe an understanding of real world business drivers is critical.
 Our holdings are dominant operators in niche areas and their exposure to fast-growing economies around the world should continue to sustain profitability.”

Darwall said stockpicking has been key to recent outperformance, with names such Reed Elsevier, Wirecard and Amadeus among contributors.

“These share certain characteristics although are engaged in totally different business activities.
 They are beneficiaries of digital technology, have extensive multinational interests and can claim some unique, strong and sustainable points of differentiation.”

Looking forward, he said profit margins in Europe are already high by historical standards so it is reasonable to question whether further increases are realistic.

“We believe ‘winning’ business models can deliver further improvements in profitability.
 For companies with highly differentiated, unique products and services, where there is evidence of pricing power, prospects remain good. As never before, these companies are able to deploy their advantages worldwide.”

Henderson boasts two funds in the top 10 over three years, with its managers John Bennett and Richard Pease both positive on opportunities, at least in the medium term.

Bennett, who runs the European Focus fund, says the continent has been a relative beneficiary of US Federal Reserve tapering concerns, as money flows have found their way back to developed markets.

“If we are to see sustained flow back to developed market equities, it will not be in a straight line.
 We expect volatility to continue and would be mightily surprised if we had heard the last of the woes of Europe’s southern periphery. Nevertheless, we would continue to draw attention to the valuation discount European equities offer against US stocks; it remains too big,” says Bennett.

Meanwhile Pease has established his European Special Situations fund as a top performer since launch in 2009, largely due to exposure to industrials and basic materials.
 He said there is rising evidence investors are looking at Europe and its companies more positively, with some arguing the improvement in economic statistics suggests a rapidly improving outlook for cyclicals and banks.

“We are more cautious, taking the view there are still many structural problems to address in countries like France, and there are significant regulatory issues still to be resolved in the banking sector.
 In the medium term we are confident of higher returns from companies with strong international positions where valuations are mostly reasonable.”

One fairly new name amongst the top performers is the Invesco Perpetual European Opportunities fund and manager Adrian Bignell notes gentler headwinds for European GDP this year.

He says: “Macroeconomic data shows signs of bottoming, monetary policy is accommodative and austerity implementation is also being scaled back somewhat. Against this less negative macroeconomic environment, European companies should fare better and the rate of earnings downgrades is already starting to slow.

“Given this backdrop, we remain focused on finding companies that can do well in a low-growth environment, which can include those with strong growth in returns on capital employed or restructuring stories. In our opinion, the attractive valuations offered at current levels underestimate the ability of European companies to deliver healthy returns to shareholders over the longer term.”

Top 5 and bottom 5 Europe ex-UK equity funds
  Top 5 funds over 3 years to 26/09/13  
1 Scot Wid HIFML European Strategic 55.2
2 Threadneedle European Select 49.6
3 Henderson European Focus 49.4
4 Invesco Perp European Opportunities 49.1
5 Baillie Gifford European 48.8
  Bottom 5 funds over 3 years to 26/09/13  
1 Marlborough European 18.2
2 HSBC GIF Euroland Equity 26.7
3 Fidelity European Opportunities 20.4
4 Cavendish European 27.8
5 CIS European Growth 21.9
  Sector average 32.3
  Total return performance figures are on a bid price to bid price basis (mid to mid for OEICs) with net income (dividends) reinvested.  
  Source: FE Trustnet  



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